The negative interest rate experiment

Brooks MacDonald

The start of this year has seen a continuation of central banks’ policy experimentations, with Japan joining the eurozone, Switzerland, Denmark and Sweden in employing negative interest rate policies (NIRPs). NIRPs can refer to economies’ base interest rates, or more specifically to negative central bank deposit rates (i.e. the interest rates that central banks pay on cash they hold on behalf of commercial banks).

The motivation for employing these unconventional policies differs between various policymakers. For some, their objective is to encourage credit growth by penalising banks for not lending, thereby boosting demand and hence inflation. Others use them to devalue their currencies and improve the international competitiveness of their economies. However, questions remain as to the efficacy of such mechanisms, particularly whether NIRPs result in lower borrowing rates for businesses and households.

One of the unintended consequences of NIRPs is that they impact commercial banks’ business models. Low rates have always hindered the profits banks can earn through traditional banking business, i.e. borrowing and lending. However, on top of this negative rates effectively add an ongoing cost to holding un-lent customer deposits. In places, this has had broader negative side effects. For example, in Switzerland certain mortgage rates have risen since the Swiss National Bank cut its base interest rate to -0.75% in January 2015 because lenders are charging higher mortgage rates to offset the costs associated with not lending out deposits. As such, the policy is actually deterring borrowers rather than encouraging lending.

the implication for pension funds is that pensioners will receive less money

NIRPs are also impacting insurance companies and pension funds. These need to generate returns on their assets in order to fund long-term liabilities and negative interest rates are making this increasingly hard to do. In the case of insurers, this will impact on their profits, while the implication for pension funds is that pensioners will receive less money, impacting on their lifestyle and spending power.

Given NIRPs’ effect on the profitability of financial services companies, their advent is weighing on investor sentiment towards the financial sector. This was highlighted in the sharp sell off in Japanese financial equities following the Bank of Japan’s (BoJ) surprise decision to adopt negative rates in February to boost inflation. We question the ability of negative rates to support inflation in Japan as they are reducing upward pressure on bank wages by weighing on bank profitability. As such, they could actually have a deflationary effect.

However, central bankers are become more considerate of NIRPs’ negative effects. In its most recent monetary policy meeting, the European Central Bank moved its deposit rate further into negative territory, but also announced measures to allow banks to avoid penalising deposit rates. Specifically, it introduced policies through which commercial banks will essentially be paid to increase lending, thereby offsetting the costs of holding deposits.

Beyond the economic impacts, there are also practical implications to consider. These are wide ranging and have included the need to adjust financial contracts, to clarify tax treatments and to modify clearing and settlement systems. So far, these side effects have led central bankers to signpost the timing and potential for NIRP use; for example, the Bank of Canada recently reduced the estimated lower bound for its policy rate from 0.25% to -0.50%.

The jury is still out on whether the benefits outweigh the risks associated with such unusual policies. However, given our subdued global growth outlook we expect central bankers to continue to experiment with non-standard policy tools in order to stimulate their economies. Such experiments could continue to support asset prices as long as investors hold some optimism that they will work, although we also expect investors to question the rationales behind such measures until there is clear evidence that they are positively affecting economic activity.


The above article by Claire Bennison was first published by Brookes MacDonald on 24th May 2016.