In today’s world of unorthodox central bank policies, negative interest rates have become the new norm. Introduced in 2015 and 2016 by the European Central bank and the Bank of Japan to support economic growth, the rates theoretically reduce borrowing costs to stimulate economic activity, but they also can generate distortions in economic behavior.
The byproducts of negative-rate policies
Perhaps the most obvious effect of negative central bank interest rates is that they have magnified the downward pressure on government bond yields. As the spreading contagion of negative yields in our table shows, this pressure is widely felt across the bond-maturity spectrum in many European countries and in Japan. In the weeks after Brexit, the value of sovereign debt sporting negative yields rose to more than $10 trillion before beginning to decline in the late summer.
The downside is that negative nominal yields means a lower future income stream for bondholders, which in turn reduces future spending power. Another drawback involves the earnings of financial institutions. Negative interest rates are likely to have an adverse effect on bank profitability, especially in a flattening-yield-curve environment. Banks will face additional margin pressure and reduced profits as they have been absorbing the added costs of paying to deposit funds at the respective central banks without passing on these costs to customers. This practice is not written in stone, however, and some banks have even begun charging customers for deposits in Switzerland and Japan.
An uncertain experiment
This trend of negative rates began with Denmark, which established negative interest rates in 2012 after giving the world ample warning. Concerns at the time focused on a meltdown in Denmark’s financial system, but it did not come to pass. Nor did the policy lead to a noticeable change in the various interest rates charged by Danish banks on their loans to consumers and businesses. However, when it comes to evaluating the impact of negative rates on economies larger than Denmark’s, it is still too early to gauge whether a similarly mild effect is likely to occur. In larger economies, the experiment with negative rates has had a much shorter track record.
Ultimately, negative rates in Europe and Japan may stimulate economic growth. But they may also have undesirable and unforeseen economic and financial consequences — including misinterpretations by individuals and businesses alike, who, reading desperation in central bank actions, may be inclined to hang on to their money rather than invest or spend. It will take time to measure the positive and negative effects and reach a meaningful evaluation of the experiment.