Not long ago, a theory was floated that to avert an economic crisis, all central banks had to do was cut interest rates below zero and this would boost growth. That theory was then put to the test in the eurozone and Switzerland. And now, it’s failing.
In June 2014, the European Central Bank (ECB) decided to cut its deposit rate (the interest rate that it pays on reserves held by the central bank) to -0.10%. In September, this was cut again to -0.20%.
The theory was that charging banks for holding money with the central bank would force them to seek better returns elsewhere, either through investing in productive assets in the monetary union or transferring their money to safe assets overseas. In the first case, the additional productive investment would help drive up growth directly whereas in the second the capital outflows would help weaken the currency and make the region’s exports more competitive — also improving its growth prospects.
So what happened?
Well the investment channel didn’t exactly deliver. Data released in December showed Euro-area investment contracted for a second consecutive quarter, falling 0.2% in the three months to the end September after a 0.6% fall over the previous period.
But that was only one of the possible ways in which negative rates might be expected to boost growth. As the theory suggested, negative rates did have an impact on the currency helping to force the euro down. Here’s how it performed against the dollar:
The precipitous falls against other major currencies did seem to have an effect. For example, Germany, Europe’s largest and strongest economy, has been able to maintain a substantial trade surplus (meaning the value of exports has been greater than the value of imports) despite the ongoing weakness of some of its regional trading partners in Southern Europe as well as slowing growth in major emerging markets including China and Russia.
As far as the theory went, it seemed things were going (roughly) to plan. All that needed to happen now was to wait for the growth to come through and the eurozone crisis would finally be over.
Except, the growth prospects for the eurozone weren’t getting any better. In fact, they appeared to be getting worse. Why? Well, much of the money being generated from this trade appeared to be going back into foreign safe assets such as US Treasury bonds or into local safe havens such as German government debt.
This helped drive down the interest rates on that debt, driving a large chunk of it into negative territory. That is, investors have started paying the German government to hold their money for them.
Below is a chart of the German 5-year government bond yield:
Yet instead of using this effectively free money to invest, the German government has decided in its wisdom to squirrel the money away using it to run a budget surplus. In essence it is saying that it can’t find any major projects in the whole of the monetary union where it is likely to get a return greater that zero. Hardly a ringing endorsement of the region’s prospects.
Meanwhile much of Southern Europe is being forced to try and run budget surpluses in order to put government debt dynamics back into a sustainable path — and so have little scope to invest themselves.
But, although the positive aspects of negative rates failed to materialise, the negative spillover effects are certainly in evidence. The money flooding out of the eurozone needed a new home and much of it ended up moving into Switzerland, helping to drive up the value of the Swiss franc against the euro.
This poses big problems for the Swiss central bank. As they said in 2011 when they imposed a cap for how much the Swiss National Bank (SNB) would allow the currency to appreciate against the euro: “The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development.”
Interestingly, the SNB also imposed negative interest rates in December last year to -0.25% — though this time in an effort to halt the pace of capital inflows into the country. In other words, they were signalling that they would charge investors even more than the ECB was prepared to for their safe haven status.
Today it attempted to offset the impact of abandoning the currency cap, which was becoming prohibitively expensive for the central bank to maintain with market expectations of ECB quantitative easing weakening the euro further, by jamming down interest rates even more — to a historic low of -0.75%. And here’s how that went — the currency still surged:
The lesson here? Beware those advocating one easy answer to all your problems. Negative rates are great in theory, but in the messy reality of financial markets they can prove highly disruptive and counterproductive. If it is going to get itself out of its current mess, Europe will need more coordination between the central bank and governments.