Vol 12 (2015) - Issue 3

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The Low Interest Rate Challenge

Global central banks are committed to very low interest rates for a long period of time. That is true for the ECB and the Bank of Japan (BoJ), both engaged in QE. The Fed is contemplating a lift-off from the zero bound, but will do so in very measured steps.
By buying bonds, central banks have lowered interest rates to well below their long-run equilibrium, reduced interest rate risk – effectively withdrawn it from markets – and have thereby boosted asset prices with the intent to spark demand (and discourage saving). That being said, we have seen with the taper tantrum volatility episode of the summer of 2013 that the propensity of mis-pricing risk rises and eventually leads to sharp re-pricing of assets.
Negative interest rates take the argument a step further, in that they have intensified foreign exchange movements. Negative interest rates in Europe are a suppressant to global interest rates, either by forcing other central banks to follow suit or through the capital flow channel.
In the Euro area, the policy rate on banks’ excess reserve deposits at the ECB is –0.20%. Government bond yields with 2-to-5-year maturities have turned negative in several European countries. Negative rates are spreading to outside the Euro area. The Swiss National Bank cut its policy rate to –0.75%, so did the Danish central bank, while the Swedish Riksbank committed to a –0.25% rate through 2016 in an effort to keep the currency competitive.
In the US, the interest on excess reserves is +0.25%. The Fed is in policy transition but will take a cautious approach to ensure the economy can tolerate less accommodative financial conditions. In March 2015, the Fed signalled just that, lowering its 2015-2017 rate path materially. Behind this adjustment were downgrades to the Fed’s outlook for growth and inflation. The accelerated pace of dollar (USD) appreciation since the second half of 2014 likely reduced the Fed’s view on export growth and import prices. The associated capital flows will also limit the upward adjustment in US long-term yields typically associated with the Fed’s interest rate lift-off.
Policy divergence with other central banks will continue to be played out in the foreign exchange markets. One consequence is a global monetary policy coalescing around three major blocs, the USD-, Euro- and a combination of USD/Yen bloc, unveiling policy tensions in emerging markets.