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2016-03-10 08:09:44
By Andrew Walker BBC World Service economics correspondent
The global financial system appears to be venturing further into the bizarre
world of negative interest rates.
Let's call it Alice in Financial Wonderland.
On Thursday the European Central Bank is expected to take additional steps to
stimulate the eurozone economy, including a further cut in an interest rate
that is already below zero.
Why is this so odd?
Think about what interest is. The lender gets paid interest for allowing
someone else to use their money. But when the rate goes below zero the
relationship is turned on its head. The lender is now paying the borrower. Why
would anyone do that? Some reasons below.
Of course, this situation only applies to a limited number of financial
relationships. No-one will pay you to spend on your credit card. But this
unusual state of affairs does exist.
The ECB's deposit rate, which applies to money parked overnight by commercial
banks, already stands at minus 0.3%.
Does that make the ECB president Mario Draghi the white rabbit - the one who
led Alice into Lewis Carroll's subterranean fantasy world? Or perhaps there is
a whole family with fluffy tails whose warrens extend to the central banks of
Japan and several European countries, which have similar policies.
Japan's remarkable move
These negative rates are the policy decisions taken by a handful of central
banks. But the phenomenon has also affected the bond market, where investors
buy and sell the bonds or debts of governments and large companies.
The cost of borrowing is set when the bonds are issued. It depends on how much
the financial firms who buy the bonds pay for them - what they are buying is a
promise to make a series of payments in the future. If the price is high
enough, the borrowing cost, in effect the interest rate, can be zero or even
negative.
Last week the bond market took a new step down the financial rabbit hole.
Japan is the first government among the G20 major economies to borrow money by
issuing bonds for ten years at an interest rate of less than zero.
It's true that several other countries have done it for shorter periods and
Switzerland (which is not a G20 member) has already done it for ten-year
borrowing.
But Japan being paid to borrow money for ten years is nonetheless a remarkable
development.
It's a much bigger economy than Switzerland, with a much larger government debt
- much larger even in relation to its economy.
The usual pattern with borrowing costs is the longer you borrow for the more
you have to pay. So a negative ten-year cost is a striking thing.
Questions remain
It's worth emphasising the distinction between the two contexts in which we
have negative rates. One is central banks making a judgement about what is best
for economic growth employment and inflation. The other is private investors
accepting a negative return on an asset, which is arguably much the stranger of
the two.
So why do they? Accepting a pitifully low positive rate is one thing: it is
better than nothing. But if the rate on offer is negative, then zero, or just
sitting on the cash looks preferable.
With the latest government debt sale in Japan, one reason is thought to be
investors buying the bonds with a view to selling them later when the central
bank goes into the market as part of its quantitative easing programme, which
involves buying financial assets with newly created money.
In other cases, banks have been more willing to buy bonds with negative returns
because they are charged by the central bank if they deposit excess funds. In
some cases, foreign investors think they can make money if the currency rises
enough to compensate for the negative yield.
With central banks in the developed economies it is a policy choice to have
kept their official interest rates very low - below zero in a few cases.
One of the key reasons is something else that is also very strange - at least
by the standards of the relatively recent past. Inflation, in the judgement of
central banks in the main developed economies, is too low.
At times it too has been below zero, but in the US, Japan, the eurozone and the
UK even when above zero it has been well below the central banks' targets of 2%
or thereabouts.
Unorthodox policies
Central banks' failure to get back to the target and the persistence of
sluggish economic growth in the eurozone and Japan has led them to try
increasingly unorthodox policies: quantitative easing and negative interest
rates.
The underlying idea is much the same as cutting interest rates in more normal
times. The aim is to encourage more borrowing and spending by firms and
households. Central bank rates do not completely determine the cost of such
borrowing, but they are a major factor. Or at least they usually are.
There are some concerns that when central bank rates go negative, they have
less impact on lending rates in the private sector beyond the money markets. A
review by economists at the Bank for International Settlements said: "Questions
remain as to whether negative policy rates are transmitted to the wider economy
through lower lending rates for firms and households."
There are also concerns that they make it harder for banks to lend profitably.
The obvious alternative is fiscal policy - government spending and taxes. But
governments in the west have been reluctant to use this approach, due to
concerns about increasing government debt, although critics say those worries
are misplaced.
Back to normality
So how long before we emerge from Financial Wonderland? There was a period last
year when there were some signs that things might be starting to return to
normal. The clearest indication of that was the decision by the Federal Reserve
in December to raise US interest rates from essentially zero.
The expectation then was there would be several more hikes this year. However,
this glimmer of financial normality - signs of Alice the banker regaining
consciousness perhaps - didn't last. Now the markets think it is more likely
that the Fed will raise rates again just once or twice this year. The prospect
of any such action by the other major central banks has receded into the more
distant future.
More than seven years on from the most intense phase of the financial crisis,
the aftermath is still with us. Some things clearly have improved. Unemployment
is low in the US, Britain, and Germany and the eurozone is no longer in
imminent danger of chaotic disintegration. But there are many weaknesses and
the unusual financial conditions will not return to normal for a while.
It's getting to feel like Alice's tea party, with the clock stopped at tea
time. She certainly hasn't come round yet.