Central banks need to rethink the entire premise of monetary policy, writes Eric Lonergan
For a central banker, this was about as blunt as it gets. “I am not a fan of negative interest rates,” announced Mark Carney this month, just after cutting rates to historic lows in an effort to boost spending and reinvigorate a stuttering economy.
There are profound implications from the Bank of England governor’s dismissal of an approach that is being pursued in a number of struggling developed economies. Mr Carney calls attention to a bitter truth about a policy that has been flavour of the month for almost 40 years.
In standard economic theory, interest rates are the price we pay for instant gratification: lower rates induce us to spend more and save less. Yet Mr Carney has good reasons to be cautious: there is concern among economists about the impact of ever-lower rates on the global banking system.
The core profitmaking business of banks is “maturity transformation”, whereby banks fund themselves with short-term deposits and make longer-term loans. Bank profitability is typically determined by the difference between the interest rates they pay on deposits and receive on loans. If lending rates fall further than deposit rates, this model is challenged. Negative interest rates are even more pernicious, with banks reluctant to deduct interest charges for fear customers will respond by withdrawing cash.
Banks may be able to find ways around this, primarily by not passing on lower rates to borrowers, although this somewhat defeats the purpose of reducing interest rates in the first place. But evidence from financial markets strongly suggests the shift to negative rates is indeed undermining the performance of the financial sector. This is clearest in Japan, where bank equity prices dropped after the Bank of Japan introduced negative rates in January.
If the BoJ and other policymakers are right that the benefits to consumers and companies outweigh the costs to banks, then negative rates are worth pursuing. But there may be a deeper problem that goes to the heart of modern economics. Central bank models assume that, when real interest rates fall, consumer spending rises. Since the rise of economic liberals such as Margaret Thatcher, former UK prime minister, and Ronald Reagan, former US president, this rule of thumb has gone unchallenged. Given recent market and consumer behaviour, it looks less convincing.
The idea that lower interest rates raise demand is based on the view that households attempt to smooth their consumption over time. This assumed relationship has little empirical support and there are good reasons, particularly when rates are extremely low or negative, to doubt it. High existing debt levels, or poor creditworthiness, are more realistic constraints on spending than higher interest rates.
And what of savers? Lower rates have a depressing effect on household incomes, through reduced interest on savings and pensions. It is likely that in relatively wealthy economies — with rising healthcare costs, increasing longevity and uncertainty over pension funding — households respond to lower income on their savings by trying to save more. If this outweighs the reduced incentive to save, the actions of central banks are self-defeating. The relationship of spending to lower interest rates may well be the reverse of that assumed by policymakers. If consumers do not respond to lower rates by spending more, this places an additional onus on the corporate sector.
Yet corporate investment appears similarly unresponsive. Investment decisions have financial consequences over many years, and are more influenced by beliefs about future growth and attitudes to risk than by overnight interest rates set by central banks.
Companies have in the past few years responded to very low borrowing costs by engaging in relatively low-risk financial engineering such as share buybacks, potentially crowding out more productive risk-taking.
Mr Carney also alluded to the mixed evidence from countries that have cut rates below zero. For example, Sweden’s housing boom, which has accelerated in the past two years, has ignited fears that high and rising levels of mortgage debt could threaten financial stability.
Other aspects of monetary policy appear to have a more productive role. The European Central Bank’s Targeted Longer-Term Refinancing Operations
and the BoE’s
Term Funding Scheme target lending without affecting deposit rates or banks’ profits.
The central banks make loans to lenders at predetermined rates, which financial institutions are required to lend in turn to companies for new investment. If the rates on these loans were fixed at zero or negative levels for long maturities they could be used to fund long-term investments by companies.
Mr Carney is right: the traditional use of interest rates has run its course. For central banks to continue playing a role in preventing recession and raising growth, they will need to rethink the entire premise of monetary policy and aim their firepower directly at consumer spending and corporate investment. Expecting further cuts in interest rates to work is wishful thinking.
The scattergun approach is not hitting the target.
The writer is a macro fund manager at M&G Investments
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