The absurdities of negative interest rates

The European Central Bank took another step down the rabbit hole of negative interest rates, with US President Donald Trump eager to see the US Federal Reserve follow in hot pursuit.

The ECB’s decision last week to pull out all the monetary policy stops to reinvigorate the region’s flailing economy has again put the spotlight on the absurdities and unintended consequences of relying predominantly on negative interests to get the global economy back on track.

In his penultimate ECB meeting, Mario Draghi ignored push back from several of the major European central banks and went ahead with his package of monetary policy stimulation. Draghi gave markets all they expected, announcing that the Bank would reduce the interest rate to -0.5%, create a two-tier interest rate system and reintroduce bond purchases of €20-billion a month.

Trump’s farcical response to the ECB’s decision was a tweet calling the Fed officials “boneheads” and urging them to follow suit and reduce US interest rates to zero or below zero. This stirred up much debate, with some market participants questioning why interest rates needed to be reduced given that the US economy is still on a relatively even footing and others pointing out that, not even in the financial crisis when the world as we knew it then looked like it was going to end, did interest rates fall below zero.

Trump’s call for near- or below-zero interest rates is at odds with his puffed-up assessment of the state of the US economy, which has ranged from “incredible” to “great” to “doing just fine”. Onlookers point out that the benefit of negative rates for Trump is that they will enable him to refinance government debt and put in place new tax breaks to win favour with voters ahead of the presidential elections in 2020.

But negative interest rates could be doing the exact opposite of what more rational minds intend them to do, causing untold, long-lasting damage to the global economy.

One commentator, Wolf Richter, has gone as far as saying negative rates of return make capitalism defunct. His assessment:

“When you start thinking about it long enough, cooking up negative interest rates is like making hugely important economic decisions purposefully in the worst possible way, in order to disable the proper functioning of the economy. And when the economy stops functioning properly, these folks are surprised and then cook up even more deeply negative interest rates to solve the problem these negative interest rates have already caused.”

So what are some of the problems that negative interest rates are causing in the global economy and likely to continue coming back to haunt us?

The banking system is taking the brunt of the pain, which is ironic given that the banks are the transmission mechanism through which the goals of monetary policy are supposed to take effect. Negative interest rates are put in place by central banks to discourage banks from holding excess cash with them because they have to pay to do so in a negative interest rate environment. In practice, however, this has been depressing net interest income, which ultimately determines the profitability of the banks.

Recent research conducted by Bath University concluded that negative interest rate policies are, indeed, backfiring. It found the unintended consequences of unconventional stimulus initiative has been “to stifle domestic demand as commercial bank profits are squeezed.”

Dr Ru Xie, a member of the Bath University School of Management, explains:

“Negative interest rates are supposed to stimulate the domestic economy by facilitating an increase in the demand for bank loans. In theory, this could increase new capital investment by firms and domestic consumption, via credit creation.” But, he notes, the research shows that bank margins were being squeezed, curbing loan growth and damaging banking profits.

Another absurdity of the current negative interest rate environment is that bond investors, who are in effect paying governments for the opportunity to invest in their bonds, can actually make quite a killing out of those investments.

This has happened in Japan, where, even though yields are low, the upwardly sloping yield curves enabled bond investors to realise capital gains as the bonds got closer to maturity.

Investors in Austria’s 100-year bond have also profited substantially from the yield falling below 1%. Investors who bought the bonds in 2017 when it was issued, would have made more than a 100% return if they had sold in August 2019 when the price went above 200 cents.

As long as yields are falling, bond investors can make money, but there is a point at which this will no longer be the case and many investors stand to lose significantly. A bond market that is trading at negative yields also makes it far more difficult for investors to predict what they can expect from bonds into the future.

As an asset class that is traditionally viewed as the safe haven of the financial markets, investors coming up for retirement usually upweight the proportion of bonds in their portfolios. But, with the possibility that they will be paying for that safe-haven status rather than earning an income, the decision becomes far more complex and potentially disastrous.

Another nonsensical, unintended outcome of a negative interest rate monetary policy environment is the proliferation of zombie companies in a world where money has become cheap. Zombie companies are businesses that have been around for more than a decade and have loaded up on so much debt that they cannot afford to repay it.

Though there are always zombie companies around, the unprecedented monetary policy easing that has taken place since the global financial crisis in 2008 has meant that the number of companies that are contributing very little, if at all, to the economy has grown significantly.

The New York Times put the number of zombie companies in the US at one in six companies and Bank of America Merrill Lynch put the proportion of zombie companies in advanced economies at 13% in 2018. These figures are indicative of the extent of the problem — one that will continue to mount as long as negative interest rate policies are pursued.

The Bank of International Settlements conducted research into the rise of zombie firms and the causes and consequences. It defines zombie firms as those that are unable to cover debt servicing costs from current profits over an extended period. Its research found:

“The ratcheting-down in the level of interest rates after each cycle has potentially reduced the financial pressure on zombies to restructure or exit.”

It further found that zombie companies weigh on economic performance because they are less productive and because their presence lowers investment in and employment at more productive firms.

The BIS concluded:

“Lower rates boost aggregate demand and raise employment and investment in the short run. But the higher prevalence of zombies they leave behind misallocate resources and weigh on productivity growth. Should this effect be strong enough to reduce growth, it could even depress interest rates further.”

It is this vicious circle that many commentators are most concerned about and which we may already have entered. It is also why White House Economic Adviser Larry Kudlow was so critical of Europe’s low and negative interest rates last week.

He told a press conference in Baltimore:

“The Europe story — all this super easy money, zero and negative rates. You know, if it was going to work it would have worked. And it’s not worked.” Who could say it any better? BM