Central bank roulette

In this post-financial crisis era, investors have had to deal with 'extraordinary' monetary policies which have been applied with various degrees of success. The US kicked off first with quantitative easing (QE), setting the global benchmark for central bank policy action to combat the fallout from the largest global recession since the 1930s.

Eight years on from the start of QE and the US economy has recovered, to some extent, but for Europe and Japan, the struggle continues. The introduction of negative interest rates by both the European Central Bank (ECB) and the Bank of Japan (BOJ) is a further extension of extraordinary monetary policy and possibly the last roll of the dice.

Anything left in the toolbox?

Negative interest rates are not as complicated as they may sound and, in simple terms, they should be understood as the opposite of positive interest rates. This might be obvious, but consider a positive interest rate scenario where a bank (or deposit-taking institution) would typically pay you a rate of return on any cash balance you deposit with them.

With negative interest rates you would, in effect, pay the bank for leaving your cash with them. In reality, banks do not charge negative rates across the board. They utilise a tiered system where cash balances up to a certain level will earn a small positive rate, say 0.1 per cent, the next tier would earn 0 per cent, and all balances above that are subject to a negative interest rate. This approach has been used before: Switzerland adopted negative interest rates in the 1970s to dampen the pace of capital inflows into the country.

Theory has failed in practice

But is there any point in negative interest rates if very low positive interest rates have not helped thus far? Economic theory implies that cheaper borrowing costs lead to higher spending by consumers, as well as higher capital expenditure by business. Lower interest costs leave more disposable income for households and more profit for business to re-invest; again, this is all in theory.

The extended period of low interest rates since the financial crisis should have encouraged this shift in behaviour by both consumers and businesses, but this has yet to happen.

As a result, central banks are now trying to find alternative methods to shift behaviour by forcing investors to sell negative yielding assets (i.e. their cash balances) and buy riskier assets (i.e. bonds and equities). Arguably and most significantly, there is also the deliberate second order effect on a country's currency.

Negative interest rates make it penal to deposit cash in that particular currency, which consequently makes that country's currency unattractive to investors, ultimately affecting the strength of a country's currency. For those countries that are heavily dependent on exports to grow, negative interest rates becomes an attractive option. For Europe and Japan, with their strong export dependency, negative rates appear a feasible path to reigniting economic growth.

Another of the key factors distinguishing the European and Japanese story from the rest of the developed world is the lack of inflation in the underlying economies. The ECB's mandate explicitly requires them to maintain price stability, so as the price of goods and services fall they are, in effect, compromising their mandate. Negative interest rates should improve financing conditions which in turn should stimulate demand and push prices higher. So could we expect other developed economies to follow suit?

Each to their own

In our opinion, this would be unlikely. What may work for Europe and Japan might not be suitable for the UK and the US. More significantly, the Anglo-Saxon model of economic growth relies on the banking system to work efficiently and in an unobstructed manner.

Positive interest rates are important to bank profitability and thereby wider economic prosperity, predominately through the lending channel. It could therefore be argued that negative interest rates in the UK and US could actually hamper rather than foster economic growth.

What does appear clear is those central banks that have engaged in negative interest rate policies are based in economies which have been stagnating and struggling to find a driver for economic growth.

As long as that continues, investors will remain worried regardless of whether we have positive or negative interest rates. So what are negative interest rates good for?

Well, not absolutely nothing because on a case-by-case basis, there is a strong argument for utilising them but it's a not one-size-fits-all formula for economic growth.

Jordan Sriharan is a senior investment analyst at Thomas Miller Investment

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