Why negative interest rates will not cure deflation

by George Hatjoullis

There is a misapprehension that negative interest rates are a cure rather than a symptom of underlying deflation. Apparently this is a subtle point and not self-evident. It is disputed because there is a great faith placed in Central Banks and interest rates. After all they used interest rates to dispose of inflation did they not? Did they? My enduring memory of inflation in the 1960s and 1970s was of inflation bringing higher interest rates not resolving it. The source of the inflation was a particularly toxic mix of union power, currency depreciation (despite high interest rates) and public spending designed to ensure ‘full employment’. A wage-price spiral emerged. The inflation was disposed of by Thatcher as much through degrading union power and cutting public spending as anything the as yet not independent BoE did. The BoE basically printed money on demand and bank money was, well money! No one worried about keeping large amounts in the bank because it was going to fail. They worried because of the inflation eroding its real value. High interest rates were a consequence of the inflation not a cure.

Today the reverse situation applies. Wage power is nil (except on the London Underground it seems). Public spending is, if anything, over constrained. Bank money is no longer money above a certain amount. It is a loan to the bank and the bank might fail and you lose some of your deposit over the insured amount. For many people this may not be an issue as the £75k insured amount is sufficient cash. For pensioners living off savings, and businesses, this a very live issue. However much money the BoE pumps into the system the amount of insured deposits is capped. If the demand for cash (folding money and insured deposits) exceeds this now capped supply then people seeking default free cash-like assets will pay to lend. Negative rates and negative bond yields are the consequence of excess demand for cash. It may take unrealistically negative rates to equate demand and supply because the supply of cash, deposits, and default free bonds curve may be shifting as yields become progressively more negative.

In theory one might expect more default free borrowers to emerge as yields become progressively more negative. There is only one default free borrower in the UK and that is the state (ultimately the state is also on the hook for the deposit insurance). The UK state is not increasing borrowing but actively seeking to reduce both borrowing and outstanding debt. This is independent of the negative rates available. The supply curve (which is very inelastic) is shifting and there are less bonds to satisfy the already excess demand. Commercial banks cannot properly function in a negative interest rate environment. Reserves held with the BoE will cost money as they will have to pay the BoE to hold such reserves. Government debt will cost them money to hold. Yet prudential regulation requires such assets on the balance sheet. The commercial bank margins are squeezed and they will naturally shrink their balance sheets further. How does less bank lending help combat deflation?

There is a serious risk of a negative rate/deflation ‘equilibrium’ taking hold. I say equilibrium because it could endure longer than would be healthy (in the long run we are dead). It will take some unconventional and currently taboo policy measures to break this equilibrium, such as monetary financing of state spending or simply just more government spending funded by borrowing. Maybe a global war will make this acceptable (sound familiar?). The present turmoil in equity markets makes sense if viewed through this prism. Conventional macro policy is no longer functioning. The alternatives are taboo. The deflation is self evident. The shock will cause defaults and no one can ever be sure how the defaults will work out. Caution and capital preservation become prudent. However capital preservation and caution mean greater demand for cash and default free bonds, for which there is already excess demand. It is a deflationary spiral no less problematic than the inflationary spirals of the 1960s and 1970s. I have been warning about it for several years but largely ignored by all but one or two.

Does this means sell all equities and hold cash? No because some businesses will thrive in this environment. Costs are reducing, debt is nominally cheap and they may have strong cashflows. The problem is identifying them and getting them at a good price. Markets price such relative advantages quickly. Ironically all those that bought annuities in the last few years will be sitting pretty. Unfortunately most of us were seduced by the pension reforms into income drawdown. Not looking so smart now.

In 2010 when I first looked at this scenario I did not see this outcome. I, like everyone else, assumed, the Quantitative Easing and low interest rates would rebalance the system. In 2013 I changed my view and wrote repeatedly about it on this blog. The change arose because of the proposed EU banking reform and the experience of the Cyprus banking crisis. This suggested to me that the problems of Japan were about to become global and worsen. It appears I was correct (the blog posts are still there if you wish to check). After 5 years of QE and low, now negative, interest rates we have deflation. At what point do all the ‘smart’ people acknowledge the fact and change their view. I fear only when things get much worse.