The Central Bank Force Awakens
May 3, 2016
Since the Great Recession in 2008 and throughout modern history, central banks around the globe have utilized different forms of economic stimuli to help lift their respective economies out of recession. QE, ZIRP, LIRP – while this may sound like robot lingo from the latest Star Wars movie, these are some common acronyms you might recognize from the media - “QE” (Quantitative Easing), “ZIRP” (Zero Interest Rate Policies), and “LIRP” (Low Interest Rate Policies). More recently, however, another central bank policy has been pulled out of the toolbox to help battle recessionary forces – “NIRP” (Negative Interest Rate Policies).
The Foundation of NIRPs The global banking system has been structured on the notion that banks and individual investors should earn interest on deposits held at central and commercial banks. This assumption is no longer a certainty, at least for commercial banks. The European Central Bank (ECB) and Bank of Japan (BOJ), among others, are now charging commercial banks 0.4% and 0.1%, respectively, on excess deposits held at their central banks. That’s right; it now costs commercial banks to save in the Eurozone and Japan! As odd as this may sound, negative interest rates are intended to have positive consequences. NIRP is intended to encourage banks to lend money rather than save it, leading to a higher level of borrower spending. In theory, an increase in spending is expected to boost economic activity and stock markets over time, which is beneficial during periods when deflation is present or a risk. Negative interest rates are also intended to encourage currency depreciation, benefitting domestic exporters as their products become cheaper to consumers abroad.
Possible Consequences As is common with all central bank policies, there are possible adverse consequences of NIRP. Commercial banks have not passed negative rates on to the individual consumer, e.g. charging consumers to hold their money in bank accounts. There is fear among policy makers that doing so would lead to a run on banks as individuals rush to empty their accounts to avoid paying a penalty for saving. Banks are now paying interest on their excess reserves held at central banks and crediting interest on savings within their own vaults. This is damaging bank profitability which poses a risk to financial stability. Another point of concern is directed toward bond investors. Declining interest rates increase bond prices; this translates into lower yields for investors who depend on bonds as a stable source of income and capital preservation. The current yields on AAA-rated five-year and ten-year government bonds in the Eurozone are -0.3% and 0.2%, respectively.1 Compare that to the five-year and ten-year Treasury bond yields of 1.3% and 1.9%2 here in the U.S. where short-term rates have been increased.
Are NIRPs Coming to the U.S.? Despite the reality of NIRP overseas, the U.S. is on the opposite path with respect to central bank policy. The Fed Funds futures contracts market is currently pricing in a 41.6% likelihood of one rate hike by June and a 30.3% likelihood of two rate hikes by December. Current levels of inflation in the U.S. expunge the need for NIRP to battle deflation. The Consumer Price Index for all items increased 1.0% over the past 12 months ending February 2016.3 Although below the Fed’s target of 2.0%, inflation is on the rise. All things considered, improving economic circumstances in the U.S. indicate that the likelihood of NIRP being implemented in the U.S. anytime in the near future is extremely low.
Data Sources: 1European Central Bank (www.ecb.europa.eu), 2U.S. Department of the Treasury (www.treasury.gov), 3Federal Reserve Economic Data (FRED) (research.stlouisfed.org)