This article was first published in the May 2016 international edition of Accounting and Business magazine.

Central bankers aren’t usually rebels. Unlike politicians, they try to avoid generating excitement or headlines. But over recent years this cadre of officials have consistently bent or broken financial rules in their struggle to boost economic growth. The most recent central bank innovation is perhaps the most iconoclastic of all - negative interest rates.

‘Perhaps the most basic assumption in finance is that you get paid for lending out your money,’ says Mark Calabria, an expert on financial regulation at the Cato Institute in Washington and a former Congressional aide. ‘Pushing interest rates below zero stands that assumption on its head.’

The Bank of Japan became the latest member of the negative interest rate club in January, joining the likes of the European Central Bank, the Swiss National Bank and monetary authorities in Denmark and Sweden. As a result, nations representing around a quarter of global gross domestic product are now in this sub-zero territory.

Will their gambit succeed in reinvigorating global growth? And what does it mean for investors, especially those approaching retirement?

The first point, economists observe, is that negative rates do not yet mean that ordinary savers have to pay to keep cash on deposit at their bank. ‘What we are talking about here is commercial banks in these nations being required to pay to keep their reserves with their central banks,’ says Julian Jessop, chief global economist at Capital Economics, a consultancy. ‘The idea is that this makes it undesirable for banks to keep cash idle and increases their incentive to lend it out to businesses or consumers.’ This in turn should boost economic growth. 

So far the banks have refrained from directly passing on the cost to savers by deducting interest from their savings – such a move might prompt a withdrawal of cash, potentially culminating in a run on the banks. ‘This is not supposed to affect the person on the street,’ Jessop adds.

As well as pushing banks to lend more, negative rates have been viewed by central banks as a means to keep national currencies weak. ‘In theory, negative rates should repel international capital since they impose a cost on holding a currency,’ says Win Thin, a currency strategist at Brown Brothers Harriman in New York. ‘That is appealing to policymakers in Europe and Japan, where a weak currency has been seen as a way of averting deflation by increasing the price of imported goods while boosting the profitability of exporters.’

An additional bonus is that negative rates should boost stock markets. ‘The goal is to lower the return on safe government bonds and so to push investors towards riskier assets, such as equities,’ says Thin. 

Squeezing the banks

Despite this logic, many economists are sceptical that it will work. One potential worry is that negative rates risk damaging the banks. ‘This is a squeeze on bank profitability,’ says Mark Zandi, chief economist at Moody’s, the rating agency. Negative rates narrow the margin between what banks are paying depositors and what they can charge borrowers. ‘If profits suffer too much, then instead of lending more, banks may actually reduce the funds available for companies and consumers,’ Zandi says. 

It is too early to say whether this is what is happening. In the eurozone, where rates have been below zero since June 2014, lending by banks has been improving. Still, it is possible that banks will progressively lose their lending firepower if rates move further into negative territory. Zandi says: ‘It is worth noting that lending has been growing slower than the economy as a whole, so we have certainly not been seeing a surge in bank activity.’

That leads on to a second potential unintended consequence of negative rates, Zandi warns. ‘A flagging financial services sector isn’t great for stock markets either,’ he argues. The financial sector makes up 15% of the capitalisation of the European market. In Japan, banks rank third, accounting for 14% of the Nikkei 225. This may help explain why stocks in Japan lost about a tenth of their value in the two weeks after the central bank pushed rates below zero.

Foreign exchange markets too have so far bucked economic theory. ‘The Japanese yen actually strengthened about 6% against the US dollar in the two weeks following the Bank of Japan decision,’ Thin points out. ‘The lesson from this is that interest rates are not the only factor that guides the value of a currency. In the case of the yen, the currency tends to rise in value in periods of fear in global markets. This effect has so far easily overwhelmed the impact of a small interest rate penalty.’

Finally, ultra-low or negative rates may end up having a perverse effect on saving. ‘Low interest rates may actually encourage people to save more and spend less – the opposite of what policymakers want,’ says Calabria. ‘If you are saving up for retirement and will be reliant on interest payments, you need a far bigger pot of savings if rates are ultra low.’ 

In 2015, UBS economists calculated that if interest rates were 0.5%, a new retiree would require about US$1m in savings to generate an annuity that paid US$3,000 a month for 30 years of retirement. If interest rates were one percentage point higher, the same annuity would cost only US$870,000. Making up that additional US$130,000 by retirement would require an extra US$700 a month of savings for a 50-year-old. A 60-year-old would need to save US$2,200 a month extra. 

‘After a certain number of years of such extreme monetary policy, large segments of the population will conclude that they need to be more prudent with money and actually set aside more,’ Calabria says. ‘Expansionary monetary policy backfires.’ 

So given the limitations of negative rates, do central banks have more options? The answer from most economists is ‘not many’. Having already pushed the frontiers, the scope for further innovation by monetary officials is limited. 

Reverting to TLTRO

Zandi believes that if the side effects of negative rates become too pronounced, central bankers can revert to a policy used in the immediate aftermath of the financial crisis – effectively underwriting the lending activity of commercial banks. Under targeted loan operations – known in Europe by the acronym TLTRO – several central banks offered commercial banks access to ultra-cheap credit linked to the size of their lending to companies and individuals, excluding mortgages. ‘That is tantamount to the central banks making loans themselves,’ says Zandi.

Beyond this, extra central bank measures become progressively more extreme – and therefore politically unpalatable. Among the most radical » option is the so-called ‘helicopter drop’, in which a central bank creates money that can be deposited in the bank accounts of citizens. ‘This could have some potential advantages,’ says Zandi. ‘But it is the kind of solution that traditionalists would fight hard against. And it is also the kind of policy that has led Zimbabwe to hyperinflation.’ Only in the bleakest of economic conditions might policymakers attempt the helicopter drop.

With only such extreme options left, many economists are asking whether the time has now come for central banks to stop trying to save the day alone. ‘Low interest rates and the accumulation of debt can only take an economy so far,’ says Alex Pollock, a fellow at R Street Institute, a Washington-based think-tank, and a former bank chief executive. 

There’s growing suspicion among economists that innovations by central banks may be discouraging politicians from seeking more durable ways of improving economic growth. ‘It has become easy for politicians to get lazy if the central bankers are willing to do all of the work,’ says Calabria. ‘If you think that the only cause of slow growth is a lack of economic demand, then low interest rates are a big part of the solution. If you believe that economic structures in Europe and Japan especially need to be reformed – with less regulation and more flexibility – there are other more lasting solutions.’ 

Central banks may need to keep some powder dry for the next recession, economists argue. ‘In terms of lowering the cost of debt, you get a bigger absolute effect moving interest rates from 5% to 1% than from moving from 1% to zero,’ says Pollock. ‘Ultimately, therefore, it could be a problem if interest rates are already ultra low – say 1% or 2% – when the economy enters its next downturn.’ 

So rather than pushing rates into negative territory, many economists now believe that central bankers have more to gain in the long run by gradually shifting rates back towards a more normal range, making it better to prepare for the recession to come. As a result, many economists and investors are now yearning for the days when central bankers were a bit less creative. 

Christopher Fitzgerald and Fernando Florez, journalists