Page 8 of 18 Focus September 16, 2016

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1 Page 8 of 18 Focus September 1, 1 What s Negative about Negative Rates? Financial markets are starting to fret over the possibility of less-friendly central bank policies whether more Fed tightening or less easing by the ECB and Bank of. Yet, the bigger picture is that policy rates are still incredibly low almost everywhere, and any serious stumble in the global economy could force many more central banks to consider a negative interest rate policy (NIRP). The Fed has largely steered clear of the discussion, while the BoE s Carney has stated he is not a fan. However, some other central banks have indicated that NIRP is a realistic possibility, most notably the Bank of. Considering the evidence at hand on the success of negative rates so far, and considering the stage of the business cycle, we would side with Mr. Carney s sentiments on the need for NIRP. Douglas Porter, CFA Chief Economist douglas.porter@bmo.com Sal Guatieri Senior Economist sal.guatieri@bmo.com The Experience So Far Five developed nations have negative policy rates. Ranked from lowest to highest (i.e., least negative), they are:,, Sweden, the Chart 1 Euro Area, and (Chart 1). has the longest history of Parking Fee negative rates (four years), while has the shortest (half a year, thus we underplay its results in our analysis). The experience in the other three nations ranges from 1½ to years. Policy Rate Table 1 (last page) shows the trend in bond yields, currencies, credit growth, prices and economic performance since the start of negative interest rate policies in each region. Keep in mind that the relatively short history and small sample makes it impossible to disentangle the effects of negative rates from other policies in these regions, including other unconventional easing measures such as asset purchases. Although we can t draw firm conclusions about what would have happened in the absence of negative rates, we can at least infer whether the program had the intended effect of promoting growth and lifting inflation toward the central bank s target. There is little doubt that NIRP has helped lower long-term interest rates. While sovereign bond yields have fallen similarly in other nations, they have not turned negative as in many NIRP countries (Chart ). The policy has led to negative mortgage rates in, as well as sub-zero corporate bond yields for some European companies. Despite pressuring bond yields lower, NIRP has had limited success in weakening currencies (though that hasn t stopped the Swiss National Bank from trying). Only the euro and Swedish krona are below pre-nirp levels, while the yen and Swiss franc remain powerhouses. Memo to central bank generals: NIRP is more pocket knife than machine gun in a currency war. Apart from, loan growth has been positive in NIRP nations (Chart 3). However, with the exception of Sweden, credit growth remains modest and insufficient to drive strong capital spending SRB Repo (Sweden).5 SNB 3-mnth Libor. () BoJ DNB Deposit ECB Deposit -.5 () Chart Governments Getting Paid To Borrow 1-Year Government Bond Yield Germany Sweden Australia

2 Page 9 of 18 Focus September 1, 1 While business investment has risen sharply in Sweden and picked up moderately in the Euro Area, it remains weak in the other NIRP nations. One can only pity s banks, which have wrestled with not only weak loan volumes but also the cost of holding excess reserves at the central bank. While increased investment has led to robust GDP growth in Sweden and some improvement in the Euro Area, weakness in the other NIRP countries suggests the policy is no panacea for economic woes. Still, it may have helped reduce joblessness (Chart ). In fact, job growth has been decent in the NIRP countries, which, alongside a slow-growing labour force, has allowed unemployment rates to fall rapidly (in ) or stay low (in and ). Structural problems in the Euro Area have held its jobless rate above 1%, though this is 1½ ppts lower than two years ago. For most central banks, expansionary monetary policy is a means to an end, which is to keep inflation on target. Judged by that singular goal, NIRP has missed the bullseye. While the program may have lessened deflation risks, it has yet to translate into an increase in inflation (Chart 5). In fact, none of the five NIRP regions has higher core CPI rates today than when the program started. In fact, core inflation threatens to turn negative in and. NIRP appears to have had more success in lifting house prices, thereby supporting household wealth and spending. It may have stanched an earlier drop in s home prices, and could explain the near double-digit pace in Sweden. Time will tell whether a bubble ensues, however. So, NIRP appears to correlate with lower bond yields, better credit growth and higher asset prices (housing), as well as improved labour markets. Although central banks with negative rates are no closer to reaching their inflation goal, a lower jobless rate will at least increase the odds of achieving it in the medium term. However, similar trends in credit markets and the economy occurred in countries that did not adopt negative rates. The benefits of NIRP, to date, appear limited, while the potential long-run costs are yet unknown. Weighing NIRP s Negatives The evidence above suggests that there may have been some limited economic benefits from negative rates. But, there are no free lunches in economics, so let s consider the potential costs of NIRP, some of which may not yet be manifest: NIRP risks fomenting financial froth, perhaps in ways and sectors that are not yet obvious. Bubbling home prices in many countries, rising commercial real estate values, and near-record Chart 3 Credit Rising Slowly in Most NIRP Nations (y/y % chng) Private Sector Loan Growth Australia 1 1 Sweden Euro Area Chart Joblessness Has Fallen In Most Countries Unemployment Rate 1 Euro Area 1 1 Sweden 8 Chart 5 Core CPI Australia Inflation Still Very Low In NIRP Nations (y/y % chng) Euro Area Sweden - -

3 Page 1 of 18 Focus September 1, 1 equities in others may be an early sign of excessive risk taking in a low or negative interest-rate environment. NIRP risks being counter-productive by: Undermining confidence: The oddity of negative rates themselves may weigh on sentiment by sending the signal to households and businesses that something is seriously amiss in the economy. Locking in deflationary sentiment: Negative and falling interest rates may simply reinforce the message that prices and costs are going nowhere fast. Pummeling savers: Extreme low and even negative yields can force households to save more, not less, in order to meet future retirement goals. This has been the case in many countries, including Sweden, and the Euro Area. Households that increase contribution rates to make up for the shortfall will have less income to spend during their working years. Straining pension funds: The extra pressure on pensions from negative rates could force some companies to trim capital spending to help offset the increased cost of keeping defined benefit plans solvent. Pressuring commercial banks: Many banks are simply unable or unwilling to drive deposit rates into negative terrain, while lending rates grind relentlessly lower. This puts even more pressure on bank earnings in countries where growth is already extremely constrained by weak demographics. NIRP is partly a zero sum game. There is no boost to global growth insofar as negative rates merely weaken one currency against another one economy s gain is another s loss. NIRP leaves the policy-option cupboard almost empty. What does a central bank do for an encore if negative rates fail to spur growth and inflation in any meaningful way? There is a risk that if NIRP is employed at a time when supply side issues, rather than soft demand per se, are the cause of weak growth, the public will effectively believe the central bank emperor has no clothes if the results are mixed. If the public believes NIRP is ineffective, this could render central banks nearly powerless to battle the next downturn and threat of deflation. Bottom Line: We believe that negative rates should be a break the glass in case of emergency policy tool, and there simply is no fire at present. is the only major country in true deflation, and it has been there for decades. Unemployment rates are gradually grinding lower in most major economies as old financial crisis wounds heal. While negative rates may have had some limited success in supporting growth and the jury remains very much out on even that front the risks they entail as well as the lack of further room to move on policy suggest that central banks are already leaning too heavily on this risky policy crutch.

4 Page 11 of 18 Focus September 1, 1 Table 1 NIRP: So How s That Working Out? Euro Area Sweden Policy Rate (%) Current Year Ago Target Rate deposit 3-mo Libor repo deposit policy When NIRP Started Jun 1 Dec 1 Feb 15 Jul 1 Feb 1 1-year Gov t Rate¹ (%) Current Year ago When NIRP Started Trade-wtd. Currency² (% chng) From Year Ago When NIRP Started Real GDP Growth (y/y % chng) Current Year Ago When NIRP Started Unemployment Rate (%) Current Year Ago When NIRP Started Employment (y/y % chng) Current Year Ago When NIRP Started Core CPI Inflation (y/y % chng) Current.8 unch Year Ago When NIRP Started House Prices (y/y % chng) Current ³ Year Ago When NIRP Started Loans to Private Sector (y/y % chng) Current Year Ago When NIRP Started ¹ Weekly data. Financial Times. Except Euro Area, which is the German 1-year rate from Reuters ² Weekly data. JPMorgan Broad Nominal Index ³ s figure is the Urban Land Price Index

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