Interest rates – don’t be so negative

With the Covid-19 outbreak and related measures having pushed the global economy into recession, the discussion about negative interest rate policies (NIRPs) has heated up. Central banks that have not yet resorted to such policies, including the Federal Reserve (Fed) and the Bank of England (BoE), are under pressure to consider ‘going negative’ as well.

Central banks that have been running a NIRP for a number of years – such as the European Central Bank (ECB), Swiss National Bank (SNB) and the Bank of Japan (BoJ) – are increasingly searching for ways to mitigate their negative side effects, as the net marginal benefits of NIRPs seem to be diminishing. Or, put differently, because the so-called ‘reversal rate’ – the unobserved, theoretical rate at which an accommodative interest rate policy starts to reverse its intended effect – is rising over time. This begs the question how fashionable NIRPs will be in five years from now.

We see three scenarios regarding the potential prevalence of NIRPs over the coming years:

• Revenge of the reversal rate – which envisages an end to the NIRPs

• Further negativity – which assumes that NIRPs are here to stay and may be embraced by more central banks in developed markets

• Deep dive – which foresees the widespread adoption of deeply negative policy rates

The history of negative rates goes back to just after the global financial crisis, when Sweden’s Riksbank became the first central bank to introduce them in July 2009. It lowered its overnight deposit rate to -0.25%, but as the amount of funds parked overnight was tiny, the impact was negligible.

The real adoption of negative rate policies, however, occurred in 2014 when the ECB, Danmarks Nationalbank, the Riksbank and the SNB all cut their key policy rates to below zero percent. The BoJ followed in January 2016. This is shown in the chart below:

The reasons why these central banks embraced such policies are manifold. Negative policy rates seem to have helped bring down market interest rates and bond yields. As such, they have helped reduce nominal financing costs for many governments, consumers and businesses.

NIRPs are also seen to have incentivized banks to expand lending volumes so as to avoid negative interest on their excess reserve holdings with the central banks. And they lower financing conditions via the exchange rate, especially for open economies.

But they also have potentially negative consequences. Savers get depressing returns, it puts pressure on life insurance companies and defined-benefit pension funds, and it dampens banks’ profitability. The point at which the detrimental effects on the financial sector start to outweigh the benefits is known as the ‘reversal rate’ and was estimated to be -1.0% for the Eurozone in 2019.5

The Riksbank ended its five-year experiment with negative interest rates in December 2019, when it raised the main policy rate by 0.25% back to zero. The move was rationalized by the changed inflation outlook, and fears that bank lending to households in Sweden may have been more subdued than normal under an expansionary monetary policy.

After the Fed cut its funds target rate to zero in March 2020, the US central bank ruled out negative interest rates for three reasons. First, the US financial industry is set up differently than in other countries, with the important role of money market funds as a saving vehicle a distinguishing factor. Second, the effect on financial institutions’ willingness to lend is uncertain. Third, the evidence of the effectiveness of negative rates in other countries was mixed, with a BoE report in particular warning about their effect on smaller banks and the provision of credit to the economy.

Since then, the Covid-19 crisis has made NIRP adopters more susceptible to the negative side effects for banks in particular, and put non-adopters under pressure to at least reassess their stance. Going back to the three potential outcomes for negative rates, we assign the following probabilities.

Revenge of the reversal rate: a 30% chance that most, if not all, of the four central banks currently running a NIRP end it by 2025, and the Fed and BoE resist going negative as well.

Further negativity: we divide this into two outcomes. We assign a 40% probability that ongoing NIRPs remain in place at the ECB, BoJ, SNB and DN, with increased efforts to mitigate the negative side effects, especially for banks. While the BoE and Fed could apply negative rates in some of their lending programs, they refrain from taking the key policy rate negative.

We then assign a 20% probability to the sub-scenario that besides ongoing NIRPs by the ECB, BoJ, SNB and DN and smaller central banks such as the Reserve Bank of New Zealand and the Riksbank, both the BoE and Fed also introduce modestly negative policy rates within the next 12 months, after first expanding the size and scope of their QE programs.

Deep dive: a 10% probability that deeply negative policy rates (of up to -1%) are implemented over the next few years, with strong efforts to mitigate the negative side effects. This scenario would not just apply to the Eurozone and Japan, but also in the US, the UK and some other developed countries.

These probabilities could shift. But we currently believe that the chance of a number of additional developed market central banks adopting an NIRP is roughly the same as negative rates being ended within five years by those who currently maintain them (i.e. 30%).

This article is an excerpt of a special topic in our five-year outlook.