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Are you Ready for Negative Interest Rates?

Saturday, February 20, 2016 12:49
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(Before It's News)

Dear PGM Capital Blog readers,

In this weekend blog article, we want to elaborate on the possibilities and consequences of negative interest rates.

INTRODUCTION:
Imagine a bank that pays negative interest. Depositors are actually charged to keep their money in an account.

As crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero and kept them there for more than a year.

Now Japan is trying it, too. For some, it’s a bid to reinvigorate an economy with other options exhausted.

Others want to push foreigners to move their money somewhere else. Either way, it’s an unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire.

If negative interest rates work, however, they may mark the start of a new era for the world’s central banks.

THE BACKGROUND:
Negative interest rates are a sign of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans to businesses or to weaker lenders. 

Rates below zero have never been used before in an economy as large as the euro area.

While it’s still too early to tell if they will work, Draghi said in January 2016 that there are “no limits” on what he will do to meet his mandate. Europe’s central bank chose to experiment with negative rates before turning to a bond-buying program like those used in the U.S. and Japan.

The European Central Bank's new chief Mario Draghi gestures during his first press conference at the ECB in Frankfurt/M., western Germany, on November 3, 2011. The European Central Bank's decision to cut its key interest rates in a surprise move was

The European Central Bank’s (ECB) chief Mario Draghi

Policy makers in both Europe and Japan are trying to prevent a slide into deflation, or a spiral of falling prices that could derail the economic recovery. The euro zone is also grappling with a shortage of credit and unemployment near its highest level since the currency bloc was formed in 1999.

THE CURRENT GLOBAL PICTURE:
The Bank of Japan surprised markets on January 29, by adopting a negative interest-rate strategy.

The move came one and a half years after the European Central Bank became the first major central bank to venture below zero. With the fallout limited so far, policy makers are more willing to accept sub-zero rates.

  • The ECB cut a key rate further into negative territory on December 3th 2015, even though President Mario Draghi earlier said it had hit the “lower bound.” It now charges banks 0.3 percent to hold their cash overnight.
  • Sweden also has negative rates.
  • Denmark used them to protect its currency’s peg to the Euro.
  • Switzerland moved its deposit rate below zero for the first time since the 1970s.

PGM CAPITAL COMMENTS:
In what could well be a final act of desperation, central banks are abdicating effective control of the economies they have been entrusted to manage.

First came zero interest rates, then quantitative easing, and now negative interest rates — one futile attempt begetting another.

Just as the first two gambits failed to gain meaningful economic traction in chronically weak recoveries, the shift to negative rates will only compound the risks of financial instability and set the stage for the next crisis.

The adoption of negative interest rates by Central Banks – initially launched in Europe in 2014 and now embraced in Japan – represents a major turning point for central banking.

MW-EF803_neg_ce_20160218112938_ZH

By the end of 2015, about a third of the debt issued by euro zone governments had negative yields. That means investors holding to maturity won’t get all their money back.

By imposing penalties on excess reserves left on deposit with central banks, negative interest rates drive stimulus through the supply side of the credit equation – in effect, urging banks to make new loans regardless of the demand for such funds.

All of this speaks to the impotence of central banks to jump-start aggregate demand in balance-sheet-constrained economies that have fallen into 1930s-style “liquidity traps.”

Japan exemplifies the modern-day incarnation of this dilemma. When its equity and property bubbles burst in the early 1990s, the keiretsu system – “main banks” and their tightly connected nonbank corporates – imploded under the deadweight of excess leverage.

But the same was true for over-extended, saving-short American consumers – to say nothing of a eurozone that was basically a levered play on overly-inflated growth expectations in its peripheral economies – Portugal, Italy, Ireland, Greece, and Spain. In all of these cases, balance-sheet repair preempted a resurgence of aggregate demand, and monetary stimulus was largely ineffective in sparking classic cyclical rebounds.

In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans.

In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead.

Janet Yellen USA Federal Reserve Chair Lady

Janet Yellen, the U.S. Federal Reserve chair, said at her confirmation hearing in November 2013 that even a deposit rate that’s positive but close to zero could disrupt the money markets that help fund financial institutions.

Two years later, she said that a change in economic circumstances could put negative rates “on the table” in the U.S.

It remains to be seen whether the Fed will resist the temptation of negative interest rates.

The shift to negative interest rates is all the more problematic.

Given persistent sluggish aggregate demand worldwide, a new set of risks is introduced by penalizing banks for not making new loans. This is the functional equivalent of promoting another surge of “zombie lending”.

These are uneconomic loans made to insolvent Japanese borrowers in the 1990s.

Until next week.

Yours sincerely,

Suriname Times foto

Eric Panneflek



Source: http://www.pgm-blog.com/are-you-ready-for-negative-interest-rates/

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