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Interest-Rate Limbo—How Low Can You Go?

Just when it seems like monetary policy has gotten as abnormal as possible, a monetary authority says, “Hold my beer.” Among the more extraordinary examples is and has been Japan, where the Bank of Japan is considering ways to force already negative interest rates further negative.

This is the painting of oneself into a corner. On one hand, Japan is carrying a tremendous government debt load—well over 200% of GDP at last count. On the other, all that government spending seems not to be generating the anticipated economic activity. Rather, growth is stagnant, as is inflation, while the population is declining—a deadly combo. Meanwhile, the government’s hyper-focus on keeping exports up requires it to maintain an artificially undervalued yen.

In an increasingly globalized world, no country operates in a vacuum. Japan’s actions produce Newtonian global reactions, and other countries’ reactions prompt further action from Japan. In this self-perpetuating, unwinnable race to the bottom, to the winner go some highly dubious spoils—among them, negative interest rates. But interestingly, most central bankers seem willing (for now) to outright ignore those whom negative rates hurt. To wit, incoming ECB head Christine Lagarde told the European Parliament in August negative rates have already had a positive impact: “All things considered, in the absence of the unconventional monetary policy adopted by the ECB—including the introduction of negative interest rates—euro area citizens would be, overall, worse off.” A highly debatable claim, at the very least, if you consider the harm done to savers, including pensions and endowments, many of which have fixed allocation requirements. People with savings in pensions, in particular, are counting on those investments to support their retirements in the future. Negative rates throw that future into question.

Artificially low and negative interest rates also allow zombie governments and companies to persist because they can borrow for free. This isn’t a long-term winning proposition, though, given inherent questions about the soundness of those governments and corporations and the downstream impacts their demise could have on the broader economy—if and when rates finally rise.

And then of course there’s the banks. There has been a palpable and persistent desire to take a pound of flesh from the banks since the global financial crisis—so it’s hardly surprising there’s not much sympathy for the banks struggling with low interest rates. But the problem is all of the developed world and a good portion of the developing world consists of credit-based economies, which in turn are predicated on fractional reserve banking. Take away the ability for banks to sustain profitable lending (let alone introduce a situation in which they lose money every time they lend it), and the whole system eventually crumbles—or perhaps just weakens considerably.

Which is why we’re increasingly hearing from bank CEOs. JPMorgan Chase’s Jamie Dimon said in September, “I don’t think we’ll have zero rates in the US, but we’re thinking about how to be prepared for it, just in the normal course of risk management. Obviously, you’ve got to worry about the long-term effect of those interest rates.”  Even outgoing ECB head Mario Draghi acknowledged negative rates weren’t necessarily an unmitigated positive in March 2019, when he indicated the ECB would attempt to mitigate any harmful side effects, monitoring how banks could “maintain healthy earnings conditions while net interest margins are compressed.” Lagarde, though, seems to take the opposite view: “With regard to the impact of negative rates on banks’ profitability, empirical analysis suggests that the negative effects on banks’ net interest income have been so far more than offset by the benefits from more bank lending and lower costs for provisions and impairments due to the better macroeconomic environment, which to a significant extent is a result of accommodative monetary policy.” In other words, where would we be without the central banks?

Perhaps the most pernicious damage is done by the impact on confidence—which is admittedly hard to quantify but whose implications are far-reaching. In fact, it seems plausible that by its very nature, excessively accommodative monetary policy creates the very conditions requiring further accommodation, leading to a negative feedback loop. Consider: A major central bank (let’s say in Country A) signals its economy is weak, the outlook uncertain, and therefore increases stimulus (by whatever means—bond purchases, lower or negative rates, etc.) in an attempt to encourage corporate borrowing and economic activity. But if it’s true the local economy is weak and the outlook is uncertain, what CEO or CFO worth their salt would rationally conclude it would be a good time to borrow and expand business—no matter how low the rate? So, the stimulus goes largely ignored, negative rates take their toll, and a reacceleration is not prompted.  And then it begins to spread globally—the countries that interact heavily with Country A (call them Countries B and C) recognize that if Country A truly is slowing, their economies could very well be next, so they’d better follow suit and loosen their own policies. And so on until you’re playing a global game of interest-rate limbo—how low can you go?

It all rather makes one long for the old days—before the Fed and other central banks began pushing toward “increased transparency.” Maybe things were better when we needed the cereal-box secret decoder ring to decipher what Greenspan was saying. Now, we know exactly what every central banker thinks at every moment. And we know right now that they all think global economies are teetering on the brink and in need of more accommodation, not less. Why would anyone borrow to grow their business in that environment?