Question – What do you do when you really need someone to spend money?
Answer – You tell them they’ll lose it if they don’t.
Spending is the lifeblood of an economy. At a social level many people frown on consumerism and materialism, but the fact is that economies function based on the transmission of goods and services from producers to consumers.
The reason spending is so integral to an economy is because every dollar (euro, yen, yuan) spent represents another person’s income; reduce spending, and you reduce aggregate levels of income. Reduce spending enough, and the whole system can gradually come to a stop.
That’s why central banks have, for years, combated periods of slow economic growth by enticing consumers, businesses and governments to spend. Historically, they have achieved this by lowering interest rates. This has the effect of simultaneously reducing the cost of money, and also the burden of existing debt.
The chart below shows the 10-year Treasury rate over the last three decades. The trend toward lower interest rates is very evident, and this represents a massive tailwind from an economic perspective. Through all the ups and downs of the last three decades, all the booms and busts, the overarching trajectory for interest rates has been down, resulting in a long-term simulative effect.
The US is not alone in this practice of stimulating growth by lowering interest rates to encourage more spending. All major economies have engaged in this behavior. The yield on the Japanese 10-year bond is shown below, and you can see the same pattern.
The problem, or so economists thought, was that this tailwind would dissipate as interest rates hit the zero bound. Economic theory previously suggested that negative rates were impossible, since cash carries an implicit interest rate of zero percent, but it turns out that’s not the case. Rate cuts below zero are not only possible, but so far seem to provide similar effects as rate cuts above zero.
This means that instead of saying, “ah well, it was a good run we had juicing the economy for the last 30 plus years, better get used to slow or nonexistent growth from here on out since we ran out of performance enhancers,” central bankers went out and found a new drug.
In the beginning of this article you’ll notice I used the words “entice” or "encourage" a couple of times with regard to the central bank tactics used to promote spending and economic growth. This is the typical horse and carrot scenario, with central banks using the carrot of lower interest rates to incentivize consumers and businesses to spend.
With short-term interest rates for most major economies having hit zero over the course of the last 5-10 years, this idea of “enticing” consumers and businesses to spend is going out the window.
In the field of psychology, behavioral modification comes down to a very simple two-part premise: reward good behavior and punish bad behavior. For the history of our modern economy, central banks have used the first half of this technique. Now, with the advent of negative interest rates, we’re seeing central banks embrace the second half.
This represents a paradigm shift in monetary policy. Instead of pulling, central banks are beginning to push. Instead of rewarding spending, they are beginning to penalize NOT spending.
Is this the future of central bank and economic policy? Is it possible that consumers and business can no longer be incentivized to spend even if money is essentially free, and instead must be coerced into spending by being told they will sustain losses if they do not?
That’s what negative interest rate policy suggests, and it’s becoming more of a reality.
The banner day that markets had last Friday was primarily the result of additional central bank easing, with the Bank of Japan becoming the second major central bank to adopt negative interest rates (after the ECB). Sweden, Denmark and Switzerland also have negative interest rate policies.
With five central banks now engaged in negative interest rate policy, you may be wondering whether these are the exceptions, or whether this behavior is soon to become the norm. Unfortunately, as we’ve already seen, the nature of floating currencies is likely to make the adoption of negative interest rate policies contagious.
Negative interest rates have a natural weakening effect on the domestic country’s currency, as investors flee the currency in search of higher yields elsewhere. This in turn causes underlying strength in the recipient countries’ currencies, pushing them higher.
We’ve witnessed the impact of a vastly stronger dollar over the past 18 months, and the effect on the economy (primarily manufacturing) has been substantial. We’ve watched multinational corporate profits drop as it becomes harder to sell items overseas, and those sales translate into fewer dollars back home.
The benefits that certain countries accrue by weakening their currency come at the expense of other countries who see their currencies strengthen. As a result, this type of behavior has a tendency to become reciprocal in nature, and will likely cause other countries to behave in similar fashion.
Could this be the start of a new era in central banking? It’s too early to tell but from the looks of things, negative interest rates may be a burgeoning aspect of central bank policy in the 21st century.
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