The European Central Bank (ECB) ventured further into uncharted territory this month by expanding the scale and scope of its bond-buying program and driving interest rates deeper into negative territory. No-one knows where this huge experiment will end but more and more people are concerned that the ECB’s moves will lead to unwelcome and unintended consequences.
The Federal Reserve’s gradual move towards a normalisation of monetary policy looks increasingly lonely. This direction of travel is not without risks, but it feels less worrying than the path many other central banks are now taking.
Investor reaction to the ECB’s punchy measures was initially positive. The value of the euro and bond yields fell while share prices jumped. This is a Pavlovian response to more stimulus but, as Japan experienced recently when it took its own step below zero, investors’ enthusiasm can be short-lived.
The fact is that no-one understands whether negative rates will be a good or a bad thing in the long run; a boost to activity or a sign that central banks have simply run out of ammunition.
The theory
The theory is that negative rates, like lower positive ones, encourage banks to lend money more cheaply and savers to go out and spend it. Falls in the currency raise the cost of imported goods, boosting inflation. In practice, however, things are a bit different below zero than above it.
For example, banks are reluctant to charge their customers for looking after their money. Thus far, they have instead accepted a squeeze on their profit margins, which is why bank shares bore the brunt of the sell-off earlier in the year. There is a significant risk that if savers are obliged to hold cash at the bank they will just put it under the mattress. Money that stops circulating is unproductive, the opposite outcome from that which lower rates are supposed to deliver.
If central banks adopt the Japanese solution to this problem – fudging it, so banks can continue paying interest on retail deposits – negative rates simply become a tool to reduce the value of the domestic currency. They lay themselves open to the entirely reasonable accusation that they are engaging in competitive depreciations of the currency.
The principal problem
But the principal problem with negative interest rates is the signal they send out that central banks are bereft of ideas. A related problem is that they are fighting the last war, obsessing on inflation as the main measure of the health of the economy. Gently rising prices are seen as an indicator of a steadily growing economy. Recently that has been true, but in the 19th century falling prices signalled not an absence of demand but technological advancement, rising productivity and more purchasing power.
Contrast the counsel of despair that’s being promoted by the ECB and Bank of Japan with the steady return to confidence exuded by the Fed. In the short run, investors may warm to more stimulus. Surely it’s better to focus on the improved health of the banks and the growing confidence among businesses and consumers that justifies a return, even if it is a glacial and shallow one, to monetary normality.
That must be better than the Alice-in-Wonderland world in which investors buy government bonds that they know will incur a loss if held to maturity. There are only two justifications for doing that: if prices fall even faster, so the real value of your capital still rises; or if you can find an even greater fool (such as a central bank with an expanded bond-buying remit) to pay you an even sillier price.
Run out of bullets
In a world in which further stimulus might constrain rather than encourage growth, central banks have run out of bullets. The solution, as the International Monetary Fund points out, is for governments to join the fight, building on monetary policy with expansionary fiscal measures and structural reforms to increase productivity.
For investors who seek the diversification benefits of bonds in a balanced portfolio, the universe of acceptable instruments is narrowing. Stuck between the return-free risk of government paper and the high yields but rising default risk of junk bonds, top-quality corporate bonds look like the sweet spot – especially now the ECB is buying such securities.
