Why negative interest rates won’t work

There are two things to consider when it comes to Stephen Poloz; one is a certainty, the other is increasingly likely.

We know for a fact that the governor of the Bank of Canada loves to use metaphors in describing the economy and monetary policy. When oil prices soared he compared them to valuable old hockey cards. He once said his communication style resembled a duck. He even noted the similarity between the manufacturing sector and a maple tree.

While it isn’t a certainty, it is increasingly likely that Poloz and his colleagues at the Bank of Canada will lower their policy interest rate into negative territory at some point, should the economy continue to deteriorate. A growing number of economists and market watchers expect the central bank to follow in the footsteps of the European Central Bank, the Swiss National Bank and the Bank of Japan in embracing negative rates. As it stands, the Bank of Canada’s key interest rate is 0.5 per cent, which leaves two quarter-point rate cuts before it hits zero. Beyond that, negative interest rates are a possibility Poloz himself has raised, although he has been careful to say he doesn’t expect to use them.

His professed optimism aside, there are reasons to believe the Canadian economy may continue to worsen. For one thing, the full effects of the oil crash have probably yet to be felt. More workers will be laid off, more capital spending plans curtailed and more supply will hit the housing market in places like Calgary and Fort McMurray.

Speaking of real estate, the single biggest threat to the economy is that those markets that remain extremely elevated—Vancouver and Toronto—come crashing down. So much of the nation’s economy is now driven by real estate that a housing bust would surely cause a serious recession.

Negative interest rates are now quite probable (perhaps in tandem with quantitative easing). The problem is, negative interest rates won’t help the economy. So with a nod to Stephen Poloz, it’s only fitting that we use three metaphors to explain why.

Pushing on a string

This adage, attributed to John Maynard Keynes, has often been used to illustrate the point that monetary policy can be very effective in cooling down an economy but much less potent when the economy is weak and interest rates are already very low. You can pull the economy back if it’s tied to a string, but you can’t push it forward. At this point, further cuts by the central bank may not induce banks to lend, or to pass on rate cuts to consumers.

Louis-Philippe Rochon, a professor of economics at Laurentian University, is in the camp that says negative interest rates won’t work because they amount to pushing on a string. In essence, if banks are pessimistic about the economy, they will be hesitant to lend, irrespective of what the central bank does. As he explained recently:

“As we have seen with respect to the last two [Bank of Canada] rate decreases, banks have been unwilling to pass through the full effect of the decreases and will continue to resist. It is possible that by lowering rates to zero or below, banks will pass only a tiny portion of this to borrowers.”

In an interview, Rochon said the Swiss National Bank’s foray into negative rates is instructive for Canada: even though the central bank’s interest rate has fallen below zero, mortgage loan growth has slowed and rate cuts have not been fully passed on by banks. In addition, non-mortgage loans haven’t taken off since the SNB instituted its sub-zero policy.

Throwing Gas on the Fire

Let’s say the Bank of Canada does cut its interest rate below zero, possibly because of a continued and worsening situation in resource-dependent provinces. In this scenario, even if banks don’t pass on all of the central bank’s policy easing, there’s a chance that mortgage rates nevertheless do come down somewhat. This is not something the central bank should encourage. As it is, Canada is in the midst of a huge housing bubble that has left the country’s households in record levels of debt. Throwing gas on the housing fire would only make the eventual crash even worse.

If a central bank cuts rates in the forest…

How banks and consumers react to possible negative interest rates in Canada depends on the health of the economy when they are introduced. At the moment, banks are still lending and consumers are still borrowing. But post-housing bubble, both banks and consumers could turn ultra-cautious. Banks may be in no mood to lend, particularly if they don’t deem many people or companies credit-worthy borrowers. And consumers might enter a state of debt aversion, deciding that it’s better to pay off existing debts than borrow more, even at ultra-low interest rates.

In his December speech, Poloz actually alluded to the likelihood that borrowers won’t meaningfully respond to further rate cuts, noting that, “There is evidence that consumers and businesses respond less to interest rate declines when interest rates are already very low. And there is evidence that their responsiveness is also lower when confidence is low and they are trying to reduce debt.”

History shows how ineffective rate cuts are when widespread deleveraging occurs. When the Japanese commercial property market collapsed, the Bank of Japan cut rates close to zero. But overleveraged companies weren’t tempted to take out new loans; they were busy repairing their balance sheets. This phenomenon, dubbed a balance sheet recession by economist Richard Koo of the Nomura Research Institute, could come to Canada and blunt the impact of negative interest rates. To use a famous philosophical question as our metaphor, if a central bank cuts rates in the forest but no borrowers are around to respond, does it help the economy?

The heavy lifting

For all the talk of negative rates and unconventional measures, it’s notable that even Stephen Poloz admits that monetary policy can only do so much. He acknowledged as much in his December remarks, observing that “the circumstances under which it may be appropriate to consider unconventional monetary policies are also those under which fiscal policy tends to be most effective.”

Said another way, if the economy gets much worse, the ballooning federal deficit will have to get much bigger. If we can use one more metaphor, the heavy lifting must be done by the federal government, not the Bank of Canada.