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Yup, negative rates were a really bad idea

Summary:
It seemed so plausible. Break through the zero lower bound and ta dah! A new scale of economic stimulus can be engineered. And yet, as the likes of us, Frances Coppola and even Downfall Hitler have been warning for a number of years, this was always a silly presumption because negative carry creates an entirely different incentive structure to that of a positive carry world. Notably, it encourages predation, monopolisation, hoarding and in some cases, even contraction as opposed to growth. As Coppola noted in 2013: So, if – say – the ECB imposed negative interest rates on excess reserves in a world which is both risky and risk-averse, how would banks behave? I can’t see any reason at all why they would increase lending. They would be more likely to look for other “safe” investments as an alternative to parking deposits at the central bank. And they wouldn’t have far to look. The debt of countries like Germany, the US and the UK is explicitly backed by government guarantee just as central bank reserve accounts are. If the yield on these bonds were higher than the negative interest rate charged by the ECB, banks would purchase these with their surplus deposits. There might also be round-tripping from banks seeking to arbitrage the difference between sovereign debt yields and central bank negative interest rates.

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It seemed so plausible. Break through the zero lower bound and ta dah! A new scale of economic stimulus can be engineered.

And yet, as the likes of us, Frances Coppola and even Downfall Hitler have been warning for a number of years, this was always a silly presumption because negative carry creates an entirely different incentive structure to that of a positive carry world.

Notably, it encourages predation, monopolisation, hoarding and in some cases, even contraction as opposed to growth.

As Coppola noted in 2013:

So, if – say – the ECB imposed negative interest rates on excess reserves in a world which is both risky and risk-averse, how would banks behave? I can’t see any reason at all why they would increase lending. They would be more likely to look for other “safe” investments as an alternative to parking deposits at the central bank. And they wouldn’t have far to look. The debt of countries like Germany, the US and the UK is explicitly backed by government guarantee just as central bank reserve accounts are. If the yield on these bonds were higher than the negative interest rate charged by the ECB, banks would purchase these with their surplus deposits. There might also be round-tripping from banks seeking to arbitrage the difference between sovereign debt yields and central bank negative interest rates. The inevitable effect would be downwards pressure on the yields on “safe” government debt in much the same manner as QE.

Negative rates, especially when legitimised through central bank policy, encourage a zero-sum game and thus become entirely counter-productive. And that remains true, by the way, even if you scrap banknotes. Then the hoarding incentive just migrates into corporate inventory or parallel value markets, with equally drastic implications on depreciation rates.

BoAML’s Liquid Insight team headed by Chris Xiao and Vadim Iaralov, in any case, are on to the problem.

As they observe on Wednesday about the effectiveness of negative rates:

Empirically, negative rates have thus far been ineffective at achieving the central banks’ objectives of curbing currency strength and boosting inflation expectations (Chart of the day). Historically, quantitative easing (QE) has been effective at raising inflation expectations. In our view, the divergence in results may be due to the market interpreting NIRP as over-reliance on monetary stimulus.

Here’s the chart:

Yup, negative rates were a really bad idea

That said, Xiao and Iaralov’s explanation for why NIRP is proving ineffective is somewhat different to our theory. They says the market is being desensitised to new forms of extraordinary monetary stimulus, and exhausted by the prospect of needing ever-increasing accommodation to achieve the same outcome.

Their concern, as a result, is that the market loses confidence in the central bank put altogether at some point in the not too distant future:

If the effectiveness of central bank stimulus continues to decline, the probability of further policy exhaustion will continue to increase and hedging tail risks becomes more attractive. Some potential scenarios are US deflation or major declines in global financial assets as implicit global central bank puts disappear.

Our point of view is different. Negative rates are a reactionary market response to excessive liquidity and a lack of productive assets to invest that liquidity in. They are a phenomenon, consequently, which is being pushed onto the central banks by markets — not one that the central banks are in any way commandeering.

The question we should be asking, as a consequence, is not whether negative rates can be an effective stimulus (they can’t), but rather what is it specifically that’s deterring investment in productive economic assets that encourage growth? We’re increasingly of the opinion that’s down to more fundamental factors like inequality and the productivity puzzle — and particularly, in that respect, to the obfuscation of market signals due to the rise and popularity of cross-subsidisation among digital conglomerate businesses.

Related links:
Is QE deflationary or not? - FT Alphaville
Negative rates are boosting corporate inventories – FT Alphaville
Negative rates as a precursor to the death of banking – FT Alphaville
Bank profits, negative rates and evidence - FT Alphaville
Why the system needs liquidity savings before it can end QE – FT Alphaville
Digital money, negative rates as Gosplan 2.0 - FT Alphaville

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Izabella Kaminska
Editor of the Financial Times’ Alphaville blog. Fights for the human.

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