Negative Interest Rates & The Deflationary Mindset

The preponderance of negative interest rates in the global bond market, comprising US$17 trillion in value and rising. This represents about one third of all high grade bonds, mostly prevalent in the Eurozone, Denmark and Japan.

 

The phenomenon of negative interest rates makes no economic sense as it means that banks (lenders) will pay consumers (borrowers) for lending them money. So instead of the borrower paying an interest on loans, the bank pays the borrower to borrow.

 

There are a few reasons for this situation to have arisen:

 

(1) The goal of the central bank in pushing down interest rates is to encourage consumers to spend instead of saving at the bank during a slowing economic climate. Commercial banks which have excess reserves with the central bank earn a certain interest rate known as the Interest on Overnight Excess Reserves (IOER) in the U.S.. By lowering this rate, the central bank will compel the commercial banks to lend out the excess cash. for the commercial bank, it is better to lend it out as the interest earned on holding excess cash is too low.

 

(2) Bond yields are negative as investors speculate that central banks will continue to engage in monetary easing policies such as Quantitative Easing and cutting interest rates. The bonds may be bought at a premium to par value and holding it to maturity will entail a capital loss. But bond investors will continue to buy these expensive bonds in the expectation that their prices will rise further and their yields will become even more negative (eg from -0.30% to -0.50%)

 

(3) Reflationary policy of central banks to encourage investors to borrow to buy assets such as equities and properties. The intended transmission mechanism is to reduce the cost of money so that people will go out to buy financial and physical assets. When asset markets appreciate, it will creat a wealth effect.

(4) There are simply too few places for large investors (pension funds, insurers and financial institutions) to store their wealth entrusted to them. Some investors are willing to pay a premium and ultimately take a slight loss because they need the reliability and liquidity provided by governments and high quality corporate bonds. 

 

Unfortunately, among these three key reasons, policymakers have failed in their objectives as negative interest rates have encouraged more saving as savers and pensioners anticipate a worse economic future and save more to fund their current and future needs. Asset bubbles engineered by reflation policies may have sustained stock markets (eg like QE in America's Wall Street) but it has failed to ignite economic growth. In Europe, negative rates hasn't helped the European economies to recover and sustain growth to above 2.0%. 

 

But more worrying is that negative interest rates and bond yields is symptomatic of a deflationary mindset among economic agents. The central bank as a key policy maker that launches negative interest rate policies is actually confirming to the public - both consumers and companies - that the economy needs drastic unorthodox measures to revive itself.

 

The two key questions facing the world economies currently are (1) will Europe and Japan continue their negative interest rates policy when their economies continue to stagnate especially in a slower global trade environment ? (2) Will the U.S. Federal Reserve bank also adopt negative interest rates assuming it hits the zero bound in an economic crisis?

 

The answer to these two question depends on the other key macroeconomic policy tool, fiscal policy. If fiscal spending can be increased (with or without regard to any self-imposed fiscal restraints), then there might be a way to push their economies out of a deflationary spiral.

 

However, fiscal spending, in many ways, is a short-term fix. It does not enhance the productivity of an economy unless the people actually benefit from better roads, more efficient public transport systems, better airports, etc. In cases such as China, how many additional highway tunnels can they build if the traffic flow in the next new tunnel is getting diminishing? So the multiplier effects of fiscal spending may be strong in six months to a year, but the long term impact will be limited. 

 

Besides, excessive fiscal stimulus will lead to higher debt burdens as governments incur ever rising fiscal deficits, which will push up the cost of borrowing and very likely result in currency depreciation as foreign capital exits the country.

 

Added to this dilemma of policy tools, is the emergence of new technologies (AI, robotics, digitalisation and business disruptions) which are gradually and steadily changing the labour market, making many people redundant and fresh graduates unemployable. These trends are by nature deflationary as overall wages will decline or not rise as fast as before. Companies may widen their profitability by employing labour saving and productivity enhancing technology. But in the end, the rising level of structural unemployment will reduce the revenues of companies.

 

These tough economic issues, apart from the ongoing trade and tech war between the U.S. and China, are keeping economists and investors awake at night as the next major economic crisis looms amidst an era of heightened uncertainties. Perhaps, deglobalisation and unilateral protectionism could be a temporary solution for countries to insulate themselves from the deflationary trends of globalisation. Or rather is it the globalisation of the deflationary mindset?