Mind the rates gap

Nandini Ramakrishnan

Earlier this month, in the continuing saga of central bank action, Sweden’s Riksbank cut its repo rate by 0.15 per cent to -0.5 per cent.

At the end of January, the Bank of Japan introduced negative deposit rates with a tiered programme. In December 2015, the European Central Bank cut its deposit rate by 0.1 per cent to -0.3 per cent. Let us not forget the two banks that were the first at this party: Denmark and Switzerland, which implemented negative deposit rates in 2012 and 2015, respectively. In the past year, we have seen short- and medium-term bond yields trade lower and lower into negative territory across the Eurozone and Scandinavia, throwing into question the very essence of a fixed income security: that the borrower should be paying the investor interest, not the other way round.

Slowing global growth and weakness in emerging economies have dragged on developed market growth projections. Inflation expectations for most developed economies have been low and continued to drop even lower over the past few quarters. The goal of low interest rates is to introduce more money into an economy and incentivise banks to lend to companies and consumers who will then spend. Cheap money encourages spending, increasing demand for goods and services.

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Banks hold capital reserves at the central bank, either to meet regulatory requirements or settle transactions. Innovations by the ECB and, most recently, BoJ have enabled them to push policy rates well below zero, but segmentation among the reserves means that not all assets are being charged negative interest rates. Certain required reserves are held with positive interest rates, but any excesses will be “charged,” which means central banks are closer to achieving their goal: to push money into the economy while not hurting the profitability of financial companies that still need to hold some capital at the central bank. The reserves subject to negative interest rates represent only a very small share of total assets in these economies. In Japan, a negative interest rate is applied to only 0.9 per cent of total bank assets. In the euro area it is applied to 2.2 per cent; in Sweden it is 2.4 per cent; in Denmark it is 3.1 per cent; and in Switzerland it is 3.5 per cent.

As such, negative policy rates have worked broadly, as the central banks had hoped in Europe: banks have not started to stockpile physical cash to avoid a negative interest charge. Japan and Switzerland have even crafted penalties for banks who stash cash in this negative rate environment.

Central banks seem willing, to varying degrees, to go even lower than they already have. While short-dated government bond yields have come down to very low levels, this does not mean consumers in these economies are shelling out money to keep their savings at the bank – yet. Currently, the pass-through to the customer on the street is low. Household deposit rates should remain around zero, but corporate deposit rates are more likely to move into negative territory, as has already happened in Denmark. As the consumer in these economies is not yet affected by negative rates, there is little in the monetary policy realm that should derail the strong, developed market consumer story.