The subtle message delivered by negative interest rates: Policy makers have no options left

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Growing talk of negative interest rates in Canada and the United States is stirring fear about what such a dramatic move by central banks might mean for savers and investors.

The biggest danger, though, may be something more subtle. If North American central banks did drag rates into negative territory, it would signal they are ready to double down on what they have already been doing for several years, with generally unimpressive results.

In real terms – that is, after accounting for the impact of inflation ­– rates on savings accounts and short-term bonds have typically been negative since at least 2015. Over that span, people who have poured their cash into bank accounts or one-year guaranteed investment certificates have steadily lost purchasing power.

To be sure, not all savers realize inflation is invisibly eroding their wealth, because the “nominal” amount they see on their bank statement still appears to be growing, if ever so slightly.

A central bank that took rates negative in nominal as well as real terms would remove this comforting illusion. But make no mistake: If you have put money into a savings account that pays you 0.5 per cent while inflation runs at 1.5 per cent – a common situation in Canada in recent years – you are already living in a world of negative real rates.

So what would it matter if rates turned negative on a nominal basis as well? In strict economic terms, it is difficult to see much of a difference.

The biggest significance would be what the subzero nominal rates would say about central bank desperation. Going negative would suggest policy makers have run out of better options to stimulate the economy.

In theory, lowering rates below zero should deliver a dollop of additional stimulus by discouraging saving and encouraging spending. In practice, though, negative-rate policies have produced lacklustre results. Across continental Europe and Japan, where subzero interest rates have been in force for years, economic growth has underwhelmed.

One problem with negative rates is that they discourage bank lending. After all, why would any lender rush to risk its money by making loans for less than no return?

Another problem has to do with how negative rates affect ordinary households. Rather than encouraging them to spend, subzero rates may spur households to save more if people fear that years of negative rates will erode the value of what they have put away and leave them poor in retirement.

Some economists now look at negative rates as the equivalent of monetary voodoo. In a lecture at the Federal Reserve Bank of St. Louis in March, Stanford University economist John Cochrane poured scorn on negative rates, arguing they require a major restructuring of banking and financial systems for uncertain results.

Tiff Macklem, the incoming governor of the Bank of Canada, sounds as if he has doubts, too. In an introductory press conference, he insisted he was comfortable with keeping the central bank’s policy rate at its current 0.25 per cent. He suggested that going negative might add to the economy’s woes. “When you’ve already got a disrupted financial system, you might want to be hesitant about introducing a new source of disruption,” he said.

The biggest reason to think rates may turn negative has to do with the price of futures contracts on the Federal Reserve’s federal funds rate, which is the key rate the U.S. central bank uses to set policy. The futures market has recently begun to register a growing belief among investors that the fed funds rate will dip slightly into negative territory next year.

If that did happen, the Bank of Canada would have good reason to follow suit. Maintaining higher rates than the United States would tend to drive up the value of the loonie, which would only add to the problems facing Canadian exporters.

But should we take the futures market’s prediction at face value? Probably not, argues John Higgins of Capital Economics. He wrote in a note that the futures market may be skewed by extreme views that don’t reflect more likely outcomes. “We still think that the chances of the U.S. central bank driving [the fed funds rate] into negative territory are low,” he said.

There are good reasons to think he is right. Any move toward negative rates would spur consumers to withdraw their money from banks and hoard cash – not exactly a boost to the broader economy. It could also spur legal battles, because it is not clear whether the Fed could legally charge negative rates on the reserves held by commercial banks at the central bank.

Bottom line: Negative rates are still unlikely in Canada and the U.S. If they did occur, their biggest message would be that times are tough and central banks are willing to give anything a whirl. But then, we sort of suspected that already, didn’t we?

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