Ground zero: Are negative interest rates the key to unlocking investment?

    3 October 2019

    Most forecasters agree that the global economy is heading towards recession and that there is little central banks can do, having exhausted their capacity for monetary stimulus since the 2008 financial crash. However, in their desperation, bankers have hit upon a new wheeze: negative interest rates.

    Normally, banks pay depositors interest for the privilege of borrowing their money — but negative interest rates mean the customer effectively pays the bank. The theory is that rather than keeping money in cash, investors would be encouraged to put their money to more productive use.

    The Danish central bank was the first to attempt this in 2012. It had been feared such a policy would lead to a run on the banks, but this didn’t materialise. The European Central Bank followed suit in 2014, and just this month lowered its deposit rate further, to –0.5 per cent, while the Swiss have been leading the field, with rates there hitting 0.75 per cent. Donald Trump has demanded that the ‘boneheads’ at the Federal Reserve, over which he has no direct control, reduce US rates below zero to boost industry and stock markets ahead of next year’s election.

    No one knows how much further rates could fall but there is concern that if they go much lower, the profitability of many commercial banks may be hit, particularly in the Eurozone. Presumably, there would come a point at which savers decided to withdraw their money and keep it under the mattress. But would that point be rates of –1 per cent, –3 per cent or –10 per cent? No one knows.

    Banks may choose to guard against runs by not imposing negative rates on small retail investors. So far, it has tended to be only corporate customers and high net-worth individuals who are charged negative rates — people who wouldn’t be able to find a mattress big enough for their cash. Nor is it easy for institutions and wealthy individuals to find alternatives to bank accounts: rival ‘safe’ assets such as government bonds also now have negative yields. There is now $17 trillion of negative-yielding debt in the world economy, which means options for switching between asset types are limited.

    Regarding smaller investors, it is less clear how they would react if hit with negative rates. Ultra-low interest rates have already diminished the attraction of saving with a bank and while there may not have been any significant withdrawals from banks, fewer people may be depositing cash in the first place. Bank of England figures show the total value of notes in circulation has increased continuously, with a 56 per cent rise in the number of £50 notes over the past five years. This sits oddly with the trend in cashless payments. In 2006, 62 per cent of all payments in the UK were made with cash, but by 2016 this had fallen to just 40 per cent. Some people appear to be hoarding cash, but it is not likely to appeal to every-one. Stuffing wads of bills under the mattress does not fit well with the modern economy. Economists have a name for the price people will pay for the security of storing money in banks: the ‘convenience yield’. Clearly, it is worth something to most bank customers, otherwise they wouldn’t bother with savings accounts which offer next to no interest.

    So much for the risks of negative interest rates, but what can we say about the intended benefits? Will a further cut result in increased business activity? Alastair Thomson, a portfolio finance director who works with a range of SME clients, has his doubts. ‘Businesses aren’t investing, even at historic low interest rates. I’m not convinced the change from +0.5 per cent base rates to –0.5 per cent would be enough to unlock investment in a way that the drop from 5 per cent to 0.5 per cent hasn’t. Also, bank lending rates are unlikely to fall below zero, irrespective of the base rate, so it will be banks that benefit, not businesses. I suspect there will be little impact on business decisions. Investment will remain weak.’

    Thanks to the last great monetary innovation, quantitative easing (QE), the world is seemingly awash with money, yet many businesses are still hoarding cash rather than borrowing to invest. Unfortunately, it seems no one can think of anything productive to do with it. For this reason, the main effect of QE was to drive up asset prices, rather than increase economic activity.

    In such an environment, what is the correct course of action for savers and investors? This is not a benign environment for those with few assets and modest cash savings. Rates are on the floor — though low inflation cannot be relied on to continue. Look at the past century and cash has been just about the worst investment.

    As financial writer Dominic Frisby puts it: ‘The decline in the purchasing power of fiat money is incredible. The pound has lost more than 95 per cent of its purchasing power in the time I’ve been alive. The interventionist experiment that is negative rates will only accelerate this process. The answer is to own assets — equities, property, gold, bitcoin, whatever. But don’t hold large amounts of cash.’

    Whether the Fed responds to Trump’s demand that it reduces rates, very low or negative rates look as if they are here to stay. And the outlook for savers is not going to get better. Whether interventionist central banking is wise is another matter. Following the 1987 stock market crash, the Fed adopted a policy of injecting liquidity to bolster asset prices. Investors realised the bank was, in effect, protecting them against losses, which fed through into higher asset prices and greater risk-taking.

    If central bankers act to prevent corrections in asset prices, malinvestments will persist, draining life from the economy. We are arguably in such a place. Penalising savers, propping up zombie companies and underwriting asset prices are no way to bring about a fair and thriving economy.