Central banks adjust interest rates to manage the supply of money. Such a process is an integral part of the monetary policy. Lower interest rates mean that loans are obtained at a cheaper borrowing cost, which theoretically should boost investment and consumer spending.

An expansionary monetary policy is adopted in a period of economic slowdown to stimulate an economy, conversely, contractionary monetary policy is aimed at slowing down an economy and prevent it from overheating.

One option to stimulate an economy is the lowering of interest rates by central banks, which will enable banks to grant riskier loans at discounted rates and accordingly, be able to maintain lower excess reserves.

Following the 2008 global financial crisis, low to zero interest rates were adopted by many leading economies as one of the tools to stimulate growth. This is highlighted by the graphical representation shown below, which compares the Euro Area Interest Rate vs the United States FED Funds Rate for the period 2007 to 2019.

The current political turmoil arising from trade wars, Brexit, coupled with a slowdown in the Global Economy, continue to intensify fears of a recession on the horizon. This raises the question whether interest rates below zero are effective in stimulating an economy.

There is widespread disagreement whether decreasing interest rates below zero is an effective expansionary Monetary Policy. Sweden was the first major economy to experiment with sub-zero rates. While the banking industry remained strong, contrary to many people beliefs, it is not obvious that the policy has been a success.

The last time Sweden adopted the sub-zero rates policy was in February 2015 in response to the Eurozone crisis. Following the implementation of the policy, the Swedish Krona has now depreciated by 15% against the euro.

Despite this, there is not clear evidence that the deflated krona stimulated exports. Moreover, as a result of the negative interest rate environment, many Swedish businesses have kept money overseas.

If Sweden had to raise its interest rates, the krona might appreciate exponentially, given that many other countries are looking to cut interest rates.

This could give rise to the danger of deflation and hurt the country’s exports. Sweden’s experiment proves that exiting the negative interest environment is trickier than the initial implementation and the benefit of which is yet to be quantified.

Another dangerous aspect of the zero and sub-zero rate environment is that it is forcing investors to on-board riskier investments. The current negative-yielding investment such as the 10-year German Bund currently yielding -0.41% as at the time of this writing, is forcing investors for alternative investments such as bonds and equities that are paying positive yields.

This, in turn, is increasing demand for bonds, which effectively is lowering bond yields and boosting up equity’s valuations, given such low and negative risk-free rates.

The hunger for positive yielding returns and riskier debt should be closely monitored. In a period of economic slowdown, such investor behaviour could hinder the recoverability of investments and make the situation worse for the economy.   

Disclaimer: This article was issued by Rowen Bonello, Research Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.