Negative rates aren’t working. Why do central banks persist?
Published in Real Clear Markets with Paul Kupiec.
Monetary policies in Europe and Japan have produced trillions of dollars of bonds with negative nominal interest rates in the hope of stimulating economic growth. Indeed, the Bank of Japan’s recent policy announcement doubles-down on this strategy by pledging to cap 10-year Japanese government bond yields at zero until the central bank hits its 2 percent inflation target.
But there is little evidence that negative interest rates are stimulating economic growth. Economic data suggest that consumers are actually saving more in countries with negative interest rates. And business investment, far from being stimulated by near-zero borrowing costs, is weak across the board. It’s time for a critical reassessment of unconventional post-crisis monetary policy experiments.
A typical consumer’s lifecycle has three phases – a borrowing phase, a saving phase and a phase for consuming savings in retirement. The aging of developed countries has increased the economic importance of the latter two lifecycle phases. While negative real interest rates benefit borrowing households, they are a tax on savers and those in retirement.
With negative nominal interest rates, prudently sock away your income for years and you are certain to receive less money than you invested. On top of that, monetary authorities worldwide target perpetual inflation, so chances are that you will face a higher price level in the future. Faced with this double whammy, economists predict that consumers should spend rather than save, but the data strongly suggest that households are compensating for negative interest rates by saving more, not less.
Recent OECD data show that, as average short-term interest rates turned negative, household savings rates increased in Switzerland, Germany, Sweden, Denmark and Japan. The OECD forecasts decade-high household savings rates in 2016 for all these countries except Japan.
Recent negative and near-zero interest rate policies have also had unanticipated impacts on business investment. If businesses followed economic textbooks, they would invest in activities that are profitable when expected revenues and costs are discounted using their average cost of funds. Under this decision rule, investment should increase when monetary policies force interest rates to zero or below, because more investments are profitable when a business’ cost of borrowing falls.
But many business mangers apparently skipped this economics lecture. Research has shown that many firms evaluate investments by discounting future cash flows using a management-set hurdle rate, not their firm’s cost of raising new funds. Survey evidence finds that firms set investment hurdle rates between 12 to 15 percent for investments similar to their existing business lines, and significantly higher for new business ventures.
Moreover, the evidence from multiple countries suggests that business hurdle rates are “sticky” over time. Firms do not appear to adjust their hurdle rates in response to changes in short-term interest rates. For example, a recent Federal Reserve Board study concludes that business investment hurdle rates have changed little since the 1980s, despite nearly double-digit declines in corporate borrowing costs.
The missing piece in the business investment puzzle is uncertainty. When businesses perceive high downside risks, they wait to invest. The delay allows firms to acquire new information and avoid potential downside losses by postponing investing until the data confirm an improved outlook. This behavior mimics the Federal Reserve and other monetary authorities’ habit of delaying action until additional data confirm the underlying economic trend.
The option to wait has the potential to put a huge drag on business investment. When monetary authorities use highly publicized, radical approaches like QE and negative interest rates and justify the policies as “insurance” against a deflationary spiral, they are themselves creating uncertainty. The more monetary authorities push the negative interest rate frontier to save their economies from disaster, the bigger the uncertainty they telegraph to businesses and consumers about downside risks.
Against mounting evidence, it is becoming harder to cling to the theory that near-zero and negative interest rates stimulate economic growth. When rates are negative, savers appear to save more, not less; retirees consume less to conserve their nest eggs; and business investment stagnates, as the value of the option to wait for an improved economic outlook grows.
But near-zero and negative interest rates do have one beneficiary – governments. Near zero and negative nominal rates reduce budget deficits because governments borrow virtually for free or even get paid to issue debt. So although near-zero and negative interest rates cloud the outlook for economic growth, these monetary policies have provided a silver lining for treasuries and finance ministries.