The curse of low and even negative interest rates
Negative interest rates in the Eurozone, Denmark and Switzerland have lately become the new tool of central banking. This has led to quite bizarre occurrences. At one stage this year, the whole Swiss yield curve from 0-16 years slipped into negative territory. Germany issued a five-year government bond with zero coupons; it was oversubscribed. Some investors are willing to pay the German government for it to keep their money without interest for the next five years.
When European quantitative easing (QE) began this week, the market tested new extremes. Last Tuesday, 10-year Portuguese government bonds (the country next in line if the Greece situation sours) were yielding 1.73%, half a percentage point lower than 10-year US Treasuries. Italy’s 10-year government bond yields reached 1.19%, the lowest for Italy since the 12th century (lower even than during the Black Death of 1348), i.e. since we have records of Italian interest rates.
Common wisdom considers low interest rates good for the economy, as people consume and companies invest more. Hence they should boost growth. Unfortunately, the story is not that simple. Especially the relation between consumption and interest rates is complex. It is true that the lower interest rates are, the cheaper the present becomes compared with the future. This would mean that households would consume now instead of waiting, and save less today, substituting present consumption for future. However, low interest rates also mean that there is less income in the future on what is saved today. For households wanting a specific income in the future, it means having to save more today and hence consume less.
The first effect is called the “substitution effect,” the second one the “income effect.” While the first pushes savings down, the second pushes them up. Numerous empirical studies have assessed which of the effects trumps the other. Unfortunately those studies are inconclusive. Exit the consumption boost channel.
The investment channel is more conclusive. When interest rates are low, costs of capital and costs of borrowing are low. Hence, we should see companies' borrowing to boost investments… unless, like in Italy, a company is unable to get a loan at those low interest rates because credit activity remains muted.
But consider Switzerland. Here credit activity isn’t clogged, and companies can use low interest rates to boost investments. It also makes even more sense to do so, because challenged by a very strong currency, companies need to reduce unit labor costs to keep a competitive edge. Substituting cheap capital for expensive labor is one way to do it. Hence, the low to negative interest rates help the Swiss exporters. However, “substituting labor” means in less technical terms laying off employees, or raising unemployment. Again an effect, which could hinder growth.
Economists at UBS Switzerland recently published a study showing that the very low interest rates are unable to compensate for the negative shock caused by the appreciation of the Swiss franc. Even in the most positive scenario, which assumes global growth acceleration, growth in Switzerland will remain very low in the coming quarters.
Many focus only on the short-run effects of very low to negative interest rates. However, the long-run effects are even more worrisome. The aforementioned study shows that the lower interest rates are, the more duress the Swiss pension system faces. Assuming a real interest rate of only 1.5% over the next couple of years - not far-fetched given the current negative nominal interest rates - would mean that the long-term financing gap in the first pillar would grow from 173% to 240% of GDP. Low rates could additionally mean that already by 2024 the Swiss Federal Social Security Funds would be depleted.
Finally, the aforementioned study shows that financial intermediaries, especially banks, which are borrowing short and lending long and hence have a large part of their revenues originating from this interest differential, come under greater stress the lower interest rates fall. Moreover, with negative interest rates, hedging the risk of an abrupt increase in interest rates becomes quite costly. This could prompt banks to hedge less than they would normally, exposing the whole sector to a systemic risk.
All in all, the low and even negative interest rate environment might appear to be a blessing at first glance, but the longer one thinks about it, the more it becomes a curse.