Some of us are old enough to remember passbook savings accounts. Deposit $100 in the bank, then come back a year later and the teller would credit you with $5 in interest. That was less than you could earn on many other safe investments, but it was convenient, dependable and insured.
Now imagine you deposit $100 in a European bank, return next year, and check your new balance: $99.70. Welcome to the strange new world of central banking in 2016, in the age of negative interest rates. And if economic conditions soften further in the United States, negative deposit rates could be coming to a financial institution near you.
Christopher HopkinsIt wasn't supposed to be this way.
Economists for decades have excogitated the hypothetical construct of negative policy rates as a response to deflation (periods of falling prices, the opposite condition to inflation), while denying their actual feasibility. The U.S. economy has suffered five significant bouts of deflation since 1872, with an average 15 percent cumulative decline in prices, but policymakers never previously entertained the possibility of setting rates less than zero. That is why the current wave of punitive rates imposed by central banks is so unprecedented and ultimately so alarming.
Nominal market interest rates have rarely but occasionally migrated below zero, typically during periods of financial instability during which safety and security become the pre-eminent objectives for holders of cash. In all cases prior to the present one, central banks like the ECB and the U.S. Federal Reserve guided interest rates down quite low but still positive. Investors seeking a safe haven then bid up prices of government bonds, driving their realized yields below zero.
In seeking a risk-free repository, large holders of cash were willing to accept a low but secure coupon, say, 0.10 percent, and were so anxious to do so that they gladly paid more than face value for bonds, resulting in a small net loss in principal. Government bonds in Europe have periodically carried negative market yields as far out the curve as 10 years to maturity, and the U.S. experienced negative short-term bond yields on at least two occasions since the Great Recession.
Still, these periods of less-than-zero rates were driven by investor risk aversion, as cash holders reasonably accepted very small but guaranteed losses during episodes of instability. Central banks guided policy rates close to zero (referred to as zero interest rate policy or ZIRP), but never below zero.
Until now. Welcome to the world of NIRP (negative interest rate policy). Sweden, Denmark and Switzerland experimented with negative policy rates (rates set by the central bank) in 2012, but the decision by the European Central Bank in 2014 to establish negative pan-European deposit rates was truly unprecedented. The ECB then doubled down in December, cutting the deposit rate to minus 0.3 percent. Japan joined the party in January, adopting a negative 0.1 percent rate on excess reserve deposits at the Bank of Japan. And last week in her Congressional testimony, Chairwoman Janet Yellen acknowledged that negative rates were on the table in the U.S.
It is difficult to overstate the significance of these developments, particularly since the global economy is still expanding and nowhere near the crisis conditions that would normally warrant such extraordinary measures. A sizable chorus of economists posits that maintaining these emergency tactics long after the crisis has past is actually impeding a more robust expansion, fueling asset bubbles, and punishing savers and retirees. Time will reveal the wisdom or folly of NIRP, but make no mistake: we are in manifestly uncharted waters.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.