The world may be at (or near) ZIRP, and in many cases mostly in Europe, NIRP, but that does not mean rates can not go any lower. In fact, the topic of "absolute zero", or what is the very lowest interest rate central banks can go to, either outright via negative rates or synthetically via asset monetization, is the topic of the latest note by DB's Abhishek Singhania titled "In search of absolute zero: why ZIRP central banks can still cut rates."
In the past month the Fed finally confirmed what we said in January, namely that it is only a matter of time before NIRP crosses the Atlantic and lands in the Marriner Eccles building, the one section in the report we found most interesting is DB's comparison of the cost-benefit between QE and negative rates.
And since either NIRP, or QE, or most likely both, are about to cross the Atlantic and make landfall in the US before the Fed is forced to launch the monetary helicopter, those who want to know what is really coming - no, not rate hikes - are urged to read this.
Negative rates versus QE, a cost benefit analysis
If there is more room for policymakers to cut rates further into negative territory, what are the pros and cons versus other monetary policies?
1. Financial stability risks: Where an economy is highly leveraged or financial conditions loose, there may be an advantage to pursuing negative rates over asset purchases, at least in the short term. Asset purchases are designed to push down term premia and hence borrowing costs for the real economy. As we have seen, negative rates could actually help to reduce leverage by encouraging banks to raise borrowing costs. On the other hand, if central banks were to commit to keep rates negative for long periods, expectations of negative rates could become embedded and result in lower long term yields resulting in similar financial stability concerns.
2. Assets available for unconventional QE: Further cuts to deposit rates may be more attractive where an economy does not have enough assets to sustain a large-scale asset purchase program. In the case of Sweden, for example, the Riksbank asset purchase program will have bought 20% of outstanding Swedish government bonds by the end of the year. Switzerland’s outstanding stock of government debt is even smaller. This is particularly problematic where buying other assets would have unwanted side-effects, such as the Riksbank buying covered bonds and exacerbating housing market risks.
In the Eurozone, despite the concerns voiced by some ECB members over liquidity in Eurozone government bond markets, the ECB has much more room on a relative basis to extend its asset purchase program. At the very least the ECB can extend the current purchase programme by 12 months to Sep-17 without expanding the range of eligible assets or changing other parameters of the programme10.
A related but different concern would be where central bank balance sheets have become sufficiently large for them to become concerned about capital losses. This is only a theoretical constraint, as a central bank could in practice operate with negative capital. In the case of Switzerland, however, concern over losses arising from a large balance sheet played an important role in the decision to abandon the open ended FX intervention.
3. FX or credit conditions channel. Negative rates have tended to be a highly effective tool for weakening currencies. Short-end rates are more correlated to currency movements than long-end rates, likely because FX investors tend to fund positions using overnight or short-end rates rather than further down the curve (chart 31).
Negative rates have also proved to be more effective that outright currency intervention. The contrasting experiences of Switzerland and Denmark serve to underline this point. SNB’s approach of targeting the size rather than price of reserves failed to alleviate pressure on the EUR/CHF floor. It was only until the SNB finally cut rates into deeply negative territory that pressure on the Swiss franc has relented, and the currency has begun to depreciate. By contrast, the Nationalbank was able to effectively defend the peg between the Danish krone and euro by aggressively cutting rates at the same time as currency intervention.
Negative rates appear to be much less effective in relaxing credit conditions in the overall economy. As we have noted, the experience of the four economies under negative rates suggests that borrowing costs may actually rise, not fall, for households once negative rates are implemented. Moreover, insofar as markets do not expect negative rates to be permanent, pass-through into assets with longer maturities may be limited.
Finally, as Praet has argued, the impact of asset purchases in reducing term premium and via the portfolio rebalancing channel is likely to be maximized when the central bank has reached a lower bound11. In the absence of a floor on front-end rates and the potential for further rate cuts the scope for potential capital gains on fixed rate assets reduces the incentive for investors to move further out along the maturity and credit spectrum.
4. Fragmentation: In the Eurozone case, deeply negative rates in combination with an active expansion of the ECB balance sheet may be additionally problematic. The excess reserves created via asset purchases are likely to flow back to banks in the core countries. This would imply that the burden of negative rates will be excessively borne by banks in the core countries. Making the deposit rates more negative would not necessarily incentivize banks in core countries to lend to banks in periphery as the opportunity cost for these banks will be the difference between market rates and the deposit facility rate rather than the absolute level of negative rates. This spread is already minimal and likely to get even smaller as excess liquidity increases.
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In retrospect, when we said that NIRP is the functional equivalent of the the "Monetary Twilight Zone", we were right: not only is there no getting out, but once you are in absolutely nothing makes sense any more. Good luck to anyone who still believes that "fundamentals" matter when making financial decisions.