The common view that has been held among economists and policymakers for decades is that monetary policy becomes ineffective at the zero lower bound (ZLB), i.e. when nominal interest rates approach zero. It was believed – and is still believed to a large extent by some orthodox economists and central bankers – that when nominal interest rates are very low, the economy might fall into a liquidity trap. J.M. Keynes spotted this risk early on. In Keynes own words: “There is the possibility…that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.” In a way, metaphorically speaking, the concept of a liquidity trap is akin for macroeconomics to the concept of a gravitational black hole in Einstein’s Theory of general relativity.
It is interesting to see that despite all the fuzz about moving to cashless societies, in the wake of the coronavirus pandemic there has actually been a surge in cash demand in the United States and in other major economies. This is reflected in the unprecedented increase in the M1 monetary aggregate. Does it mean the US economy is already stuck in a liquidity trap? Not yet, thanks to the aggressive quantitative easing policy deployed by the Federal Reserve, which consisted of supporting borrowers by providing unlimited liquidity back-stops and purchasing massive amounts of government bonds, households debt (in the form of mortgage-backed securities) and corporate bonds. Much of the measures deployed by the Federal Reserve since March has been intended to support borrowers and to counter a debt deflation, with the side effect of an “everything rally’ from stocks to gold. This has worked as expected and inflation expectations rose back from their plunge in March (cf. chart below). But what happens if growth does not pick up as expected and if unemployment stays at high levels for a longer period?
According to Keynes and his followers (e.g. Paul Krugman), in order to escape such a situation, the text-book solution is to implement more fiscal stimulus, as it would have a much stronger impact on the economy at the Zero Lower Bound than conventional monetary policy. But in the case of the United States today – as was the case for the Eurozone in 2014 – the prospect for more fiscal stimulus looks limited, given inherent constraints in a polarised political system a few months before a general election.
In the 1930s, Irving Fisher pointed out that the interest rate on a commodity, as expressed in nominal units of this commodity, cannot be negative, unless there is an associated storage cost. This idea is actually at the heart of the concept of money to which the concept of interest rate, which accounts for the time value of money – or its “convenience yield” in the jargon of commodity traders – is closely related. Along this line, IMF economists Vikram Haskar and Emanuel Kop report that the oldest known example of an institutionalized, legal interest rate is to be found in the Laws of Eshnunna, an ancient Babylonian text dating back to about 2000 BC.
Applying Fisher’s principle to fiat currencies would mean that nominal interest rates on these currencies can go below zero only if a storage cost or carry tax is imposed on money balances, be they in electronic or in paper form. The latter would be complicated and risky, as it would hurt cash holders. The former is feasible as has been explained by the former President of the Federal Reserve of Richmond Marvin Goodriend, in a seminal article on NIRP published in 2000. Goodfriend’s ideas have been put in practice in 2009 by Sweden’s Riksbank – which ended its NIRP experiment ten years later in December 2019 -, Danmarks Nationalbank in mid-2012, the European Central Bank in mid-2014, the Swiss National Bank in 2015 and the Bank of Japan in 2016.
In the case of the United States, there has been so far a strong resistance to implement negative interest rates. This might not last forever. As early as in 2016, NIRP has been included as part of the severely adverse scenario in the annual CCAR stressing-testing exercise conducted by the Federal Reserve. The results reported by Fed staff member David Arseneau show that the impact of NIRP on Banks is mostly distributional, meaning there would be as many winners as losers. Most banks could adapt to the new policy. From a macroeconomic perspective, prominent economists such as Kenneth Rogoff have been advocating the use of negative interest rates by the Federal Reserve.
What would the adoption of NIRP in the United States mean for capital markets and for the global economy?
Negative interest rates in the Eurozone and Japan have had an impact on neighbouring countries. The Swiss National Bank committed to NIRP to a great deal because of ECB’s policies, as the SNB sought to prevent an appreciation of the CHF against the EUR. Same could be said of Denmark whose economy is closely linked to the Eurozone. If the US goes NIRP this could have major consequences on a much larger scale. Let us try to assess these consequences and implications for investors.
First, the transmission of NIRP across the yield curve to longer government bond maturities will likely lead to a further compression of yield premiums and of the associated same maturity risk premiums – as has already been observed in the Eurozone and in Japan.
Plainly speaking, NIRP will give additional monetary fodder to the Great Reflation initiated by the Federal Reserve as early as in October 2019 when it resumed its purchases of government bonds and more overtly a few months later when it initiated a new QE Infinity programme, in the wake of the COVID-19 pandemic and ensuing market disruption. The initial reaction of markets to such an announcement might as well be negative as has happened many times in the past when the Fed eased its monetary policy – e.g. with QE – signalling a downward revision in its growth and inflation projections.
But going forward, NIRP would most likely lift financial assets across the board and – as a side effect – stretch further the valuations of some assets that are already perceived as very pricey (e.g. equities and corporate bonds issued by large tech and e-commerce companies) while it would further dampen the stocks of banks, insurance companies and all other businesses whose profits are positively correlated with long term interest rates and/or with the steepness of the yield curve (the later is less obvious as more NIRP would actually steepen the yield curve).
Therefore, ceteris paribus, NIRP would accentuate the K-shaped stock recoveryand the gold rally observed earlier this year (something we have already discussed in a previous edition of The Multipolarity Letter). In addition, NIRP will be transmitted to global capital markets and to the global economy through the portfolio balance channel by inciting long term investors to hunt for higher yields abroad and to increase their exposure to European and Japanese equities and/or to Emerging markets bonds and equities. This transmission channel has already been evidenced by many studies in the case of the ECB (cf. The Portfolio of Euro Area Fund Investors and ECB Monetary Policy Announcements, ECB Working Paper N° 2116, December 2017). This rebalancing effect would be compounded by the impact of NIRP on the US dollar, accelerating the greenback’s downward slide as a result. However, the fundamental difference between quantitative easing and NIRP is that the later will be felt directly – and immediately, according to the interest rate parity condition – as US risk-free interest rates serve as a benchmark for many countries whose money markets, bank lending and corporate credit market are more or less tied to the Federal Funds.
Winners and losers of the Fed going NIRP
Along the argument developed above, economies that are part of the “dollar zone” will be potential winners of the FED moving to NIRP. This is especially true for emerging economies that are highly indebted in dollars and that need to refinance their debt frequently (countries with short debt duration), especially in Latin America, Africa and the Middle East. The ultimate objective behind a further easing of monetary policy through NIRP is to move inflation expectations to a higher level. Once it achieves this, the FED’s priority will be to keep expectations anchored at that level. Therefore, longer term, NIRP should translate into (moderately) higher long term interest rates and steeper yield curves around the world. Hence, NIRP would reinforce the case for yield curve trades. In turn, this will support the dollar and lead to a widening of risk premiums across the board, as markets will expect a tightening of monetary policy. Eventually, if NIRP is successful this would signal the end of The Great Reflation rally. But we are not there yet and any post-COVID monetary policy normalisation could take years.