Negative Interest Rates and Deflation

Authors: Chan Kung and Wei Hongxu*

As the COVID-19 pandemic lingers, major central banks such as the Federal Reserve have to continue to maintain ultra-low policy interest rates in anticipation of being able to help the major economies out of the crisis.  According to the latest Fed decision, interest rates may not be raised until 2023, which means that the zero-interest rate on the dollar may need to be maintained for quite some time to wait for the economy to recover and for inflation levels to pick up again. For now, interest rates in the U.S., U.K., Norway, Australia, New Zealand, Israel, and Canada are all at 0.25% or lower, and of those countries, the U.K., New Zealand, and more central banks are likely to cut rates below zero in response to the economic downturn triggered by the COVID-19 pandemic. Japan and the eurozone have been under the monetary policy of negative interest rates for a long time. With more countries adopting negative interest rates, there are growing concerns about whether this unusual monetary policy will allow the economy to recover.

Recently, according to Reuters, there have been a number of studies by economists that have shown that negative interest rate policy will not bring economic recovery, but will rather cause more troubles. From a behavioral economics perspective, Lior David-Pur, head of Israel’s state debt management unit, said: “If your goal is to motivate people to take on more leverage [debt] and to increase investments in risky assets, then zero interest rates are actually more efficient than negative rates.” David-Pur’s study found that when interest rates fell from 1% to 0%, the positive impact on risk-taking and borrowing behavior was greatest.

The study, a rare look into consumer reactions to negative rates, tracked the investment decisions of 205 university students studying economics who were divided into four groups, each with 10,000 Israeli shekels (USD 2,921) to allocate between risk-free bank deposits and risky assets such as stocks. David-Pur said the group for which rates fell to minus 1%, actually cut leverage by 1.75%. But the willingness to borrow rose by 20% in the group that saw rates fall to 0%.It can be seen from the current stock markets in the United States and Europe that zero-interest rate and massive quantitative easing have indeed brought about a boom in the capital market, whose root is still the change of risk pricing by investors based on the reduction of borrowing costs, which has not effectively improved corporate profits and earnings.

Efforts to boost investment and consumption with a negative interest rate policy may be ineffective, instead households will increase their savings to “survive the winter”. This is because negative rates can suggest “some kind of emergency situation”, said Anatoli Annenkov, a former ECB economist who now with Société Générale. “That per se suggests that you won’t get the impact you want because people might just save more money instead of spending,” Annenkov said. His research shows that the savings rates across the eurozone dipped briefly after 2014, then continued to rise as official rates fell further below 0%. From the 2008 financial crisis to the present, major economies including the United States, have been experiencing low inflation and low growth. In fact, even though the world has unleashed a huge amount of liquidity, the global economy has not been able to change the deflationary situation.

The most worrisome aspect of negative interest rates is what Keynesian economists call a “liquidity trap“, i.e., when nominal interest rates are too low or even negative, further reductions in interest rates do not encourage business investment and only provide little stimulus to the economy. When businesses do not see demand and inflation expectations, they will not increase investment, resulting in fewer jobs and less consumption. In this case, negative interest rates and deflation can be said to be mutually reinforcing, with deflation-induced negative interest rates meaning that both households and businesses hold cash, thus dragging the entire economy into a deflationary black hole of a liquidity shortage.

From the practice of negative interest rate policies in the eurozone and Japan, many scholars also criticized the long-term negative interest rate policy, which does not bring an increase in investment, nor improvementsin inflation and economic growth. In Sweden, the first country to have negative interest rates, Fredrik NG Andersson, associate professor at the Lund School of Economics and Management, said the cost of negative rates for Sweden’s economy likely outweighed the benefits. Andersson said that borrowing did rise when rates were negative, but the money ended up invested mostly in housing, inflating property markets, and household debt.

Judging from past practice and current economic situation, the role of monetary policy in stimulating economic recovery has been greatly weakened. Even if the Fed adjusts its inflation target through technical means, there is less and less room for monetary policy to play in the current macro environment. Because monetary policy, for its part, is about adjusting the cost of capital to prevent liquidity crisis. Yet, the problem now is no longer the liquidity, but a lack of long-term growth momentum. The recovery of economic growth requires not only the increase in money supply, but also an increase in effective demand and supply from the perspective of long-term growth.

Final analysis conclusion:

Major central banks such as the Federal Reserve left interest rate policy unchanged, meaning zero/negative interest rate monetary conditions will remain in place for a long time. This suggests that the global economic downturn is causing deflation to be a longer-term trend.

*Wei Hongxu, graduated from the School of Mathematics of Peking University with a Ph.D. in Economics from the University of Birmingham, UK in 2010 and is a researcher at Anbound Consulting, an independent think tank with headquarters in Beijing.

Chan Kung
Chan Kung
Founder of Anbound Think Tank in 1993, Chan Kung is now ANBOUND Chief Researcher. Chan Kung is one of China’s renowned experts in information analysis. Most of Chan Kung‘s outstanding academic research activities are in economic information analysis, particularly in the area of public policy.