This article first appeared in Forum, The Edge Malaysia Weekly, on July 25 - 31, 2016.
Monetary policy has become increasingly complicated. We have rising interest rates in some parts of the world and falling interest rates in others. Some central banks have taken rates negative. For investors, it is important to understand how such changes in monetary policy affect the economy at large.
Lower rates can boost economic growth in three ways. Traditionally, lower rates may encourage borrowing. This is old-fashioned supply and demand. If the price of borrowing goes down, the demand for borrowing goes up.
The problem is that borrowing is not just about the price of credit. Borrowing also depends on confidence: borrowers need to be confident about their future and lenders need to be confident about the borrower’s future. If there is a lack of confidence, then borrowing is not likely to be encouraged by falling interest rates.
Lower rates may reduce savings. This is different from encouraging borrowing because confidence in the future seems to play less of a role. If savers receive a lower return on their savings, their attitude may be, “I might as well spend; there is no point in saving”.
There is an exception to this rule. If I am “saving up” — saving money to buy a car or for a holiday — then it will take longer to save the required amount if interest rates are reduced. I will therefore delay my spending.
Reducing interest rates will move money between different groups in society. Lower rates take income from people who have savings and give it to people who have debt. The fact that the Bank of England is likely to cut rates in August makes my father unhappy because he has savings, but it makes me happy because I have a variable interest rate mortgage. The bank is reducing my father's income and increasing my income. Clearly, I view this as a good thing but my father does not share that view.
If reducing rates can stimulate growth, why not keep going into negative territory? The reason, as the Swiss, Swedes and Danes have discovered and the Japanese may be about to find out, is that negative rates do not necessarily act as an economic stimulus. Negative interest rates are a tax on banks and large savers, and are thus thinly disguised fiscal policy.
Banks are legally required to hold reserves with the central bank. The central bank charges banks a negative rate of interest on those reserves. This creates a legal obligation to pay the central bank money. A legal obligation to pay a branch of the government money is commonly referred to as a tax.
If negative rates act as a tax, then the economic stimulus of negative rates is the same as the economic stimulus of increasing a tax. Increasing taxes is not generally considered an economic stimulus.
Banks can pass on negative rates to large customers, who have no choice but to hold cash in a bank. Small customers can avoid negative rates by holding physical cash. The increase in demand for high-denomination bank notes in countries with negative interest rates indicates this demand for cash.
Large bank customers may choose to try and reduce their cash holding in the face of negative rates. By spending or lending cash as their deposit rates turn negative, large bank customers may boost economic growth.
So, reducing rates should be an economic positive — although how rate cuts impact the economy will vary. Taking rates negative is less clearly an economic positive. The stimulus of negative rates will depend on whether the disincentive to save can offset the effects of the tax that negative rates represent. Investors should bear all this in mind as interest rates continue to move around.
Paul Donovan is global economist at UBS Investment Bank. His latest book, The Truth About Inflation, was published by Routledge in April 2015.