This article was written by Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).
The negative interest rate policy, as known as the NIRP, has certainly become one of the most interrogated strategies across the markets.
Let us have a quick glance to what caused the central banks to turn negative on their interest rates – what was the goal, and what went wrong.
As the subprime crisis hit the global markets in 2007-2008, liquidity in the financial markets dangerously dried up. The banks wouldn’t lend to each other as the counterparty risk rose tremendously following the bankruptcy of Lehman Brother’s in September 2008.
This liquidity crisis encouraged the Federal Reserve to provide the markets with sizable monetary support. The measures included significant interest rate cuts to cheapen lending and borrowing costs and the launch of a massive asset purchase programme (Quantitative Easing, QE) to temper the sharp devaluation in US sovereign bonds and simultaneously to inject more money into the system. Of course, the massive QE also weighed on real rates in the US.
As the crisis spilled over into the global markets, all central banks followed a similar strategy. The world stepped into a period of cheap liquidity to prevent the global financial system from collapsing, to avert a deeper global recession and to boost growth.
The slowing world economy weighed on households’ consumption dynamics. The worldwide recession brought along with it high unemployment and less spending, hence lower global inflation.
The world’s leading banks kept on cutting interest rates as the economic activity slowed and the inflation decelerated. They were hoping that companies and households would spend more if the cost of borrowing were less.
However this was not the case.
Finally, the major developed economies stepped into a zero inflation market. Japan has lost its fight against more than a decade old deflation.
Bank of Japan, European Central Bank seek inflation in negative rate territory
Failure to generate inflation, as a gauge of a better economic activity, didn’t stop numerous central banks from stepping into negative interest rate territory.
The Bank of Japan, the European Central Bank, Swiss National Bank and Riksbank are among the leading central banks applying negative rates to their borrowers, hoping that the latter would use debt and spend.
In fact, many of these central banks desperately seek inflation to fulfill their policy mandate, without even thinking why an artificial inflation would be fundamentally detrimental for their economies.
Inflation should be the result, a reward for healthy economic activity. Creating inflation per se should have never been a primary goal.
As a result, negative rate policies, besides the massive private and sovereign asset purchase programmes, have been unsuccessful in encouraging consumption and in bringing back inflation.
In fact, the Japanese markets immediately gave the opposite reaction to the NIRP by buying the yen instead of selling it, which has led to a 15% appreciation in the yen against the US dollar since the Bank of Japan’s rates turned negative nine months ago. In turn, the stronger yen further weighed on the inflation in Japan.
As of today, the nationwide inflation in Japan is -0.4% year-on-year.
What went wrong?
There are two major factors that play against the central banks’ plans to generate inflation: countries’ level of development and demographics.
As a country develops, the saving to spending ratio increases. Households prefer saving for the future, rather than spending a major part of their income because their primary needs are fully satisfied.
Also, rational individuals are expected to spend even less when the economy is not doing so well.
Hence, negative rates are by far not a good reason to increase debt, especially while the employment market is tight, wages growth is at a moderate pace and the future is uncertain.
Moreover, low-to-negative interest rates weigh on households’ savings and encourage them to save more and spend less.
Second, the low-to-negative interest rates weigh on pension funds’ returns. Given the increasing proportion of the aging population both in the Eurozone and Japan, negative rate policies are predestined to failure.
Nowadays, elderly households desperately watch their finances deteriorating as a result of negative rate policies. Their children suffer from unemployment, high indebtedness and low wages. Of course, nobody is confident enough to spend more. A good proportion of families have become net losers across generations.
Consequently, the negative rates did not help boosting inflation in developed countries, but rather eradicated consumption on multiple levels of the society. Hence, consumer prices tend to deflate in developed countries where the interest rates are pulled into negative territories.
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