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Strategy Monthly
A Commentary of No Interest (or Less)
February 19, 2016
Financial markets have a poor record of predicting economic cycles, and yet this year’s market volatility has prompted
pundits to warn that the U.S. economy is poised on the brink of a downturn. Although we disagree with that pessimistic
assessment, economic fears naturally raise the question of how the Federal Reserve might respond to the threat of a recession, and whether that response would include a negative interest rate policy (NIRP) similar to that in place in various
economies in Europe and Asia. Although we acknowledge that the Federal Reserve is loath to take any policy options off
the table, we nevertheless conclude that the probability of negative interest rates in the United States is remote. In the
following remarks, we consider the economic conditions that have prompted negative interest rates in Europe and Japan,
and compare them to the current state of affairs in the United States.
WHY SO NEGATIVE?
Having followed the U.S. example of adopting a zero interest rate policy (ZIRP) and quantitative easing (QE) in an effort
to boost economic activity, the European Central Bank, as well as the central banks of several non euro zone members,
have taken the further step over the past few years of imposing negative interest rates on some bank reserves. There are
several policy goals associated with negative interest rates.
1. Negative interest rates allow for a more flexible monetary policy in an environment of low inflation. Although central
banks control nominal policy rates, the ultimate objective is to influence real (inflation adjusted) interest rates in
order to stimulate demand. In an environment of low and declining inflation – such as that which prevails throughout
Europe – even zero (nominal) interest rates may be undesirably high once adjusted for inflation. If a central bank holds
nominal interest rates at zero, then real interest rates rise as inflation falls, leading to unintentionally tighter monetary
policy. Pushing rates below zero enables a central bank to respond to a disinflationary environment by breaching the
zero bound, thereby preserving the efficacy of traditional monetary policy.
2. There is an additional benefit from currency markets as well. A multitude of factors influence the value of
currencies, but short-term interest rates are among the most important of those factors. Negative short-term
rates should, all else being equal, depress the external value of a currency, boosting the appeal of exports. As the
nearby graph shows, net exports are significant contributors to those economies in Europe that have adopted
NIRPs. Exports are not a big part of the Japanese economy, and in the U.S. exports are actually a drag on GDP (as
the U.S. imports more than it exports).
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A Commentary of No Interest (or Less)
February 19, 2016
3. Cutting rates below zero steepens the yield curve, and therefore enhances the margins of banks that borrow
short and lend long. In theory, reducing the cost of funding improves the net interest margin and encourages
more lending. In that regard, NIRP is very different from quantitative easing – the expansion of a central bank’s
balance sheet through the purchase of longer-dated debt instruments. QE acts to flatten the yield curve by
holding down longer-term interest rates. That
Net Exports as % of Gross Domestic Product (GDP)
is good for borrowers, but not so good for
14%
banks. A steeper yield curve, on the other hand,
11.6%
12%
10.8%
provides a carrot for banks to lend more money
10%
in support of economic activity.
8%
7.2%
6.8%
6%
4.9%
4. And yet where there is a carrot, there is usually
4.3%
4%
a stick. Central banks that have adopted NIRPs
2%
have also imposed a negative interest rate on
0%
-0.9%
excess reserves held at the central bank to
-2%
punish banks that don’t lend as much as their
-3.3%
-4%
-6%
capital would allow. It is important to note
Switzerland Netherlands Germany Denmark
Sweden
Austria
Japan United States
that this applies only to excess bank reserves
Data as of 2015 estimate.
Sources: CIA World Factbook, BBH Analysis.
that surpass regulatory requirements and the
demands of the bank’s lending books, and so only about 2.5% of total bank reserves in Europe are subject to the
“tax” levied by NIRP. The incentive is for banks to lend money rather than hoard it at the central bank, and with
only 2.5% of total reserves qualifying as “excess,” bank lending is already rather efficient.
5. Banks have not (at least yet) passed negative interest rates onto retail account holders, so the cost of NIRP falls
on the institution, not its depositors. To the degree that zero or negative interest rates encourage consumers
to spend or invest funds in riskier assets, that, too, is supportive of economic growth. Yet so far banks have
held off on imposing negative rates on depositors lest deposits leave the bank altogether. Having noted that,
many depositors already pay a version of negative interest rates. Service charges are economically equivalent to
negative interest rates, and depositors in many countries have lived with those charges for some time.
COULD IT HAPPEN HERE?
If we have learned nothing else over the course of this economic cycle, then we have learned to never say never. Although we shouldn’t rule out the possibility of negative interest rates in the United States, it would represent novel monetary policy, which previously existed only in the more theoretical chapters of economic textbooks. Yes, the same could
have been said about quantitative easing in 2008, but several aspects of the U.S. economy make the hurdle for adopting
NIRP rather high. The law of unintended consequences looms large.
First, as illustrated earlier, the United States is not as reliant on exports as are various European economies, and is less
impacted (positively or negatively) by currency movements. To the degree that NIRP is intended to depress currencies
and boost exports, the benefit to the U.S. economy is limited.
The efficacy of the carrots and sticks that NIRP provides to the banking sector is yet unproven. Banks might simply not
respond to the incentive structure posed by negative interest rates. NIRP enhances the ability of banks to lend money,
but the uncertainty and novelty of it might very well dampen the willingness to do so. If banks don’t pass on negative interest rates to their depositors, then the cost of funding might not fall as much as policy makers intend, leaving the banks
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A Commentary of No Interest (or Less)
February 19, 2016
with only a stick and no carrot. If margins compress instead of expand, the ability of banks to service their own debt
might be called into question. At an extreme, this combination could lead to another credit crunch, thereby resulting in
the exact opposite of the intended effect.
We learned earlier this year that one of the stress tests imposed on domestic banks by the Fed included a scenario of
negative interest rates, which is almost certainly why the topic has become more widely discussed over the past few
weeks. The Fed took pains to note that, as larger U.S. banks operate in multiple jurisdictions, they may very likely encounter NIRP outside of the United States, and stress tests should therefore model for that. It was not intended to be a
commentary on the likelihood of imposing NIRP here at home.
Perhaps the steepest hurdle to imposing negative interest rates in the United States lies in the integrated worlds of commercial paper and money markets. Most companies meet short-term borrowing needs by resorting to the commercial
paper market, defined as loans of nine months or less, usually intended to finance accounts receivable and inventories.
As of February 17 there was a little over one trillion dollars of outstanding commercial paper in the United States. The
biggest buyer of commercial paper is the money market industry, drawn to the asset class by its short duration and high
credit quality, both of which help money markets maintain a stable net asset value of $1.00. Many individual and institutional investors rely on money market funds to hold cash, knowing that they can access that liquidity easily, and that it
will maintain a steady asset value, even if it doesn’t generate much yield in a low interest rate environment.
Negative interest rates on commercial paper would blow up this symbiosis. If money market funds had to pay to own
commercial paper, they couldn’t maintain a stable net asset value, and the economic model breaks down. In such a
scenario investors in money market funds would likely prefer to hold deposits at a bank or even cash rather than suffer
the drag of negative interest rates. The disruption to this core asset class for many individual and institutional investors
would be meaningful. At the same time, without money market funds to buy their paper, companies would have to look
elsewhere to meet short-term funding needs. Credit conditions would tighten, and the law of unintended consequences
would rear its head.
A flight of funds out of money markets would be a modest form of disintermediation, as a certain amount of cash would
leave the financial system altogether. If banks began to impose negative interest rates on depositors, the incentive to
hold cash outside of the financial system would rise, potentially leading to substantial disintermediation. Again, we hasten to note that so far no banks in NIRP environments have levied negative interest rates on retail depositors, perhaps in
fear of just such a scenario.
The psychology is rather straightforward. You like your checking or savings account because it keeps your money safe, is
easily accessible, and perhaps even earns you a little bit of interest. The $20 bill in your pocket is also accessible, but less
safe, and carries a zero yield. Yet if your banking account begins to cost you money at some point – if your bank charges
you a negative interest rate on your deposits – that $20 bearer bond in your pocket with the picture of Andrew Jackson
on it becomes an appealing store of value with a (relatively) appealing yield. Anything is better than zero, but zero is
better than negative.
At an extreme this could lead to an old fashioned run on the banks, prompted not by concerns of creditworthiness, but
simply the relative attractiveness of cash versus bank deposits. The implications for the banking sector are surpassed
only by the potential social implications. As the metaphor of money under the mattress becomes a reality, crimes such
as robbery, petty theft, money laundering, etc. would rise substantially. Once again, the law of unintended consequences
has not been repealed.
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A Commentary of No Interest (or Less)
February 19, 2016
A final uncertainty relates to the dollar’s role on the world stage.
It is one thing for securities denominated in Swiss francs, Swedish
krona, Danish krone or even the yen or euro to trade with negative
yields. It is another thing for the world’s global reserve currency
to trade with negative yields. There is no precedent for such a
scenario, and the implications for global trade and therefore global
economic activity are tremendous. The U.S. dollar accounts for
roughly two-thirds of global foreign exchange reserves.
Allocation of Foreign Exchange Holdings - 3Q 2015
Canadian $ Australian $
2%
Swiss franc
Yen 2%
5%
4%
Other
Sterling
3%
5%
Euro
20%
US Dollar
64%
Readers will recall that during various debates about the federal
debt, Congress (or certain congressmen, at least) flirted with the
idea of technically defaulting on maturing U.S. debt rather than
Data as of September 30, 2015.
lift the debt ceiling. Analysts and journalists accused Congress of
Sources: International Monetary Fund, BBH Analysis.
turning the U.S. credit rating into a political football, but where domestic pundits saw a football, international observers saw a hand grenade. The dollar makes up 64% of global reserves, and
anything that impairs the dollar, impairs trade. The uncertain implications of negative interest rates on the world’s reserve
currency probably make it an experiment not worth undertaking.
CONCLUSION
So could it happen here? Of course. Plenty of formerly impossible things have happened in the past decade, and in the
interest of considering all possibilities, analysts at the Federal Reserve are undoubtedly exploring the implications of the
issues outlined previously. Yet in the event of an economic downturn, the Fed would almost certainly return policy rates
to zero and implement another round of quantitative easing before it embraced the uncertainties and unintended consequences of negative interest rates.
G. Scott Clemons, CFA
Chief Investment Strategist
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