Negative key interest rates: A monetary game of dice

In the aftermath of the financial crisis, an ever increasing number of experiments were carried out to make monetary policy more expansionary. Negative key interest rates are the latest beacon of hope. More and more central banks are introducing negative interest rates to promote lending and thereby inject life into the economy and nudge up inflation. But now a serious economic debate has flared up between central bank representatives and international economic thinktanks over whether these goals can actually be achieved. Over the long term, negative key interest rates involve many risks of producing the exact opposite of what central bankers hope to achieve.

1.) Private households are hoarding cash
Negative interest rates are not being passed on to private households anywhere in the world at present. Yet, the longer the era of negative interest rates persists, the greater the pressure to do precisely this. The danger exists of cash being hoarded. Japan is an example of an economy where private households are busy stuffing bank notes into mattresses. Such behaviour would inevitably turn the global savings and lending culture upside down. The positive effect on economic growth and / or inflation on which central bankers are betting would be put into reverse. Further, the discussion on the abolition of cash would intensify even more.

2.) Burdens for insurers and pension funds
The low interest rates and, in particular, slashing key interest rates into the negative territory will have adverse implications for consumers saving for their retirement. The prospect of dwindling pensions prompts consumers to save even more. Consumer activity is in decline and thereby counteracting the central banks‘ actual goals which are to boost inflation and enhance growth prospects.

3.) Negative interest rates increase systemic risks
In response to the negative returns, both institutional investors as well as private investors are forced to invest in riskier asset classes. If interest rates suddenly start climbing and reduce bond prices in the process, turmoil on capital markets cannot be excluded. Monetary policy is thus becoming a major risk factor on financial markets.

4.) Dubious impact on the real economy
One obvious feature of negative key interest rates is that they have a measurable, direct impact on exchange rates rather than on the real economy. Despite negative interest rates, neither investment nor consumption activity has visibly risen in the eurozone, for example, and it is also doubtful whether this can be achieved at all. Hence, if the chain of effects is felt more via the exchange rates, the temptation exists to lower key interest rates even further into the negative zone, the intention being to prevent the currency from appreciating and, by extension, avoid a marked downturn in economic development. Low interest rates over a long term horizon also lead to misallocations which only become apparent once interest rates starting rising again, posing an additional danger to the real economy.

5.) Adverse effects on the creation of credit
Negative interest rates put pressure on the banking sector that is of major importance for the creation of credit. On the one hand, financial institutions could be lastingly compelled to respond to this by introducing fees for services previously provided free of charge. This would be at the expense of consumers and would, by extension, burden consumer activity. On the other hand, the danger even exists of higher rather than lower interest rates being charged on loans in order to ensure cost-efficient operations. This in turn could have clearly negative repercussions for loan granting. Low or negative interest rates might then have the opposite effect on loan granting than that actually intended, with correspondingly negative consequences for inflation and growth forces.

In the final analysis, negative key interest rates are a game of dice over the longer term with an uncertain outcome. The risks are high and the potentially positive effects on the real economy appear limited. Positive consequences only appear to exist for exchange rates – at least in a first response. However, the more central banks introduce negative key interest rates, the greater the erosion effects of this monetary measure will be. At the end of the day, a race for the lowest interest rate worldwide would also fail to have any lasting effect on the exchange rate.
Summing up, high risks have to be taken into account with negative key interest rates and the outcome is more than questionnable.

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