Question

Due to the covid19 pandemic negative interest rates are basically in uncharted territory, analyse and evaluate whether yield curve analysis is still valid.

Answer 1

ANALYSIS AND EVALUATION OF NEGATIVE YIELD CURVE

Since YCC (Yield curve control) carries some significant risks, why has the Fed so far been consistently reluctant to consider negative interest rates?

After all, several advanced economies have already experimented with negative rates during the past five years: The euro area, Japan, Sweden, Denmark and Switzerland—while the Fed engaged in a 2.25 percentage point rate-hiking cycle between December 2015 and December 2019. How did things play out?

Over the five years, US personal consumption expenditures grew faster than all five “negative-raters,” at 14%, followed by Denmark and Sweden; US investment grew a bit more slowly than the euro area and Denmark, but on a par with Sweden and a lot faster than Japan.

Consumer prices also increased at a brisker pace in the United States: 10% over the five-year period compared to 8% in Sweden and only 6% in the euro area.

For Sweden and Switzerland, negative rates helped make the exchange rate more competitive—for Switzerland countering the appreciating pressure on the Swiss franc (due to its safe-haven status) was an important policy goal. Since their exports account for close to half of gross domestic product (GDP), a more competitive exchange rate can give an important boost to growth—and the same holds for Denmark and the euro area. US exports are only 12% of GDP, however, so the exchange rate channel would be less powerful.

At first cut therefore, negative rates don’t seem to have given these five countries a leg up compared to the United States. Of course, there were other important differences between the United States and the five “negative-raters,” and it’s quite possible that Japan, Sweden, Switzerland, Denmark and the euro area would have suffered a weaker performance had their central banks not pushed rates below zero. But negative rates have certainly not provided a decisive boost.

You might have noticed in the first chart that none of these countries pushed rates much below zero; Switzerland made the boldest move to -0.75%. Why did they not cut even more? After all, the rationale for negative rates is that if the economy needs substantial rate cuts, but nominal interest rates are already low, the zero-bound should not be a barrier—policymakers should cut by as much as they see fit.

Well, the problem is that negative rates can play havoc with the financial sector:

• There is evidence that in Europe, where the European Central Bank has kept policy rates in negative territory for a significant amount of time, the profitability of banks has suffered;
• Pension funds have also suffered significant funding difficulties and a worrying increase in their liabilities compared to their assets; and
• In some countries, notably Germany, negative rates have caused political and social tensions because of the adverse impact on savers and the elderly.

All this with interest rates around -0.50%. Now consider that for the United States today, some estimates of the classic Taylor Rule² suggest the appropriate level of interest rates would be -16%!

No wonder the Fed is reluctant to go down that route, especially as the robust health of the financial system is one of the most important elements of resilience in an otherwise fragile economic environment.

Moreover, cutting interest rates beyond a certain point can backfire on aggregate demand—with very low interest rates, households get a minimal yield on their savings. With high uncertainty and doubts on the solvency of private and public pension systems, households can easily decide to save more and consume less.

So now look at the next two charts: between 1980 and 2000, a decline in US long-term interest rates went hand in hand with lower savings and higher consumption; over the past two decades, however, that relationship has reversed, with the savings rate rising as yields on 10-year Treasuries declined to record lows. Correlation is not causation, and the chart is not proof that lower interest rates cause people to save more. However, it does caution against hoping that negative rates would boost consumption.

Weighing the risks to the financial sector and the limited evidence of economic benefits, it’s not surprising that negative rates have not sparked the Fed’s enthusiasm. Never say never though, so it’s worth keeping this analysis in mind for the future.

REFRENCE -

FRANKLIN TEMPLETON (CHARTS)