By Ashley Kindergan
In the old days, before the world was awash in capital with nowhere to go, an announcement of monetary easing was generally considered a good thing, a sign that central bankers were on the job. Historically, in all but the most extreme circumstances, lower interest rates have tended to spur economic activity, with the contemporaneous effect of supporting risky assets. But we are clearly living in an extreme circumstance, and after eight years of such announcements from central banks, it's time to ask whether monetary policymakers are pushing on a string.
The latest example of such: the Bank of Japan's January 29 decision to apply negative interest rates to a small portion (4 percent) of commercial bank reserves. "The intended signaling was that quantitative easing could still be expanded and that the commitment to raising inflation remains strong," analysts in Credit Suisse's Global Markets division wrote in a recent report. "For us, the bigger message is that policymakers are not finding traction in combating lackluster growth and are struggling in the search for effectiveness without any real conviction."
Europe's experience has shown that negative interest rates aren't terribly effective at stimulating domestic demand, since commercial banks have refrained from passing negative rates on to depositors and customers, both for regulatory reasons and to prevent capital outflows. That offers little incentive for households and businesses to spend money instead of stashing it in the bank. Negative interest rates are also designed to encourage banks to lend, and the latest European bank lending survey does indicate that the combination of quantitative easing and negative interest rates have resulted in looser credit standards on bank loans to both households and businesses, as well as higher demand for consumer credit, mortgages, and business loans. Europe, however, has to date had a strong, consumer-led recovery, meaning there is some appetite for borrowing. In Japan, however, consumption has been relatively weak for the past year.
Instead, the primary power of negative interest rates seems to lie in their ability to weaken currencies, and Credit Suisse's Japan economists believe the Bank of Japan's main goal in introducing negative interest rates was to moderately weaken the yen or at least prevent it from strengthening. Even in this, however, negative interest rates are unlikely to meet with much success in Japan. Credit Suisse's foreign exchange experts have revised their three-month target only slightly after the announcement to ¥120 per U.S. dollar from ¥115. There are two reasons for that. First, each new central bank surprise has less impact than the last-as Credit Suisse puts it, "the novelty factor and perceived benefits" of monetary easing are declining. Second, China's growth slump and plunging oil prices have pushed interest rates lower around the world in 2016, eliminating the spread widening that usually makes foreign exchange carry trades attractive after a rate cut. Some 30 percent of sovereign bonds in the developed world are now trading at negative rates.
The declining efficacy of negative rate announcements was evident as early as January 21, when European Central Bank President Mario Draghi hinted that the ECB could cut rates in March. The euro fell for a year after the central bank first implemented negative interest rates in June 2014, but in January, the currency dipped only briefly against the dollar before stabilizing.
Yields on 5-year German bonds did drop considerably after the ECB meeting, from -0.196 percent on January 20 to -0.309 on February 2, but so, too, did the yields on five-year Treasuries, which dropped from 1.44 percent to 1.28 percent as turbulence in global financial markets sent investors running back to the safety of sovereign credits, particularly U.S. Treasuries. And the spread between European and U.S. interest rates actually narrowed from 1.636 percentage points to 1.589, removing downward pressure on the euro.
Thus, despite yields on five-year Japanese government bonds dropping a full percentage point from 0.017 before the negative rate announcement to -0.018 on February 5, Credit Suisse's currency strategists expect limited yen weakening. Lackluster U.S. economic data is likely to limit dollar strength, with manufacturing activity contracting for the fourth consecutive month in January and non-farm payroll growth of 151,000 jobs missing the consensus estimate of 190,000. Credit Suisse also sees little room for capital outflows from Japan. The largest destination for Japanese foreign investment is emerging Asia, which has had troubles of its own lately, and Japanese investors were already cutting exposure to foreign assets when the central bank announced negative rates.
Apart from its effect on the yen, it's possible that the Bank of Japan's negative interest rate policy will work against its quantitative easing program, through which it buys Japanese sovereign bonds from commercial banks. If those same commercial banks can expect to receive negative interest rates on the cash they receive from the BoJ, they're likely to hold on to their bonds, which at least pay some interest.
One thing Japan's policy is likely to do, however, is encourage other countries to ease further. That's what happened in Europe, with central banks in Denmark, Hungary, Norway, Poland, Sweden, and Switzerland all cutting rates after the ECB's negative rate announcement.
The Bank of England might dip into negative territory if manufacturing and exports continue to weaken and inflation data slows, Credit Suisse says. The central bank has said it no longer considers 0.5 percent a floor for interest rates, and its chief economist is on record saying negative rates are theoretically possible. Japan's neighbors could also ease further, even if outright negative rates are unlikely. South Korea competes with Japan in industrial goods exports and keeps a close eye on the yen/won exchange rate. Credit Suisse says the country's policymakers would likely cut rates if external demand continues to slow or domestic demand falters. Since Taiwan's technology firms compete closely with those in South Korea, the Central Bank of the Republic of China (CBC) would likely follow a Korean cut with one of its own. Japan itself may yet go further into negative territory. Credit Suisse expects that the Bank of Japan will cut its deposit rate from -0.1 percent to -0.5 percent by this summer.
If that domino effect materializes, global monetary policy could start looking like a race to the bottom-and not an entirely unsurprising one. Since the financial crisis, central bankers have been left almost entirely on their own to stimulate growth, with politicians loath to commit to significant, long-term fiscal stimulus. But it's becoming increasingly clear that central banks cannot conjure up demand on their own and that there are diminishing returns to additional easing. At this point, fiscal stimulus - whether it is in the form of tax cuts or increased spending - would likely be a more effective shot in the arm for growth than increasingly desperate monetary policy.