Interest rates around the world fell to historically low levels following the global financial crisis of 2008 and 2009, and sluggish recovery prevented them from rebounding in the subsequent years. In 2016, new waves of economic weakness exerted further downward pressure on interest rates, pushing some nominal rates into negative territory for the first time. Many economists had previously considered 0% to be an unbreachable bound in anything but the shortest of terms, but negative real rates in Japan, Germany, Denmark, Switzerland and Sweden have persisted for several months and are expected to continue. Negative rates in these economies have coincided with currency depreciation in each case, and the yen, euro, krone, krona and franc all lost value versus to the dollar and pound between August 2015 and August 2016. The Japanese yen fell nearly 18% relative to the dollar over that span.
Falling interest rates have historically coincided with currency devaluation. Europe and Japan have been threatened by deflation due to weak demand, leading central banks in those areas to conduct unprecedented monetary policy measures in an effort to create inflation and stimulate investment. However, inflation has at times fallen short of expectations precisely because there is so much excess capacity in those markets. Banks, consumers, investors and corporate management remain conservative, dampening the effects usually associated with easy monetary policy.
Interest Rates and Currencies
Central banks often implement expansionary monetary policy to combat the negative effects of recession, poor consumer sentiment or hesitant businesses investment. This is often achieved by increasing the supply of money in an economy. Open market operations are the Federal Reserve's preferred method of raising the supply, in which the central bank buys or sells securities to influence the level of reserve balances in the banking system. As the money supply rises, interest rates fall while the quantity demanded increases. This helps to stimulate business investment and consumer spending, which supports higher employment and wages.
When a central bank increases the money supply, it also causes devaluation relative to other currencies. Moreover, falling interest rates in an economy reduce the global demand for securities denominated in that home currency. This makes a country's exports relatively less expensive, assuming that prices are sticky, which can stimulate growth for export economies. Devaluation also makes foreign products more expensive.
China experienced significant currency devaluation in 2015 and 2016, with many observers attributing this policy measure to export stimulation. Some, including Donald Trump, accused the Chinese of unfair trade practices, citing the extreme degree of devaluation that coincided with headwinds affecting the country's manufacturing and exporting sectors. Other economists noted the influence of the U.S. dollar's charge on the yuan, which pulled the Chinese currency in an unfavorable direction relative to the country's other large trading partners. The People's Bank of China cut its benchmark interest rate from 6% in late 2014 to 4.4% by 2016, highlighting the relationship between currency devaluation and interest rates.
Negative Rates
Negative rates are a peculiar situation because the basic logic that dictates lending decisions seems to be violated. Providing a negative rate loan means that the creditor is losing capital while taking on counterparty risk. However, central banks have been able to install negative real rates in several countries, because investors continue to demand these low-risk securities due to uncertainty and poor returns across other asset classes.
A rush to low-risk assets does not stimulate economic growth, so rates have ventured into negative territory as monetary authorities try to promote growth. Businesses, consumers and banks that hoard cash are punished by low rates, but they have not responded as unexpected. Savings rates have risen in Germany, Japan, Denmark, Sweden and Switzerland despite negative rates. Business investment remains below expectations. Inflation has been slow to rise in Europe and Japan due to high unemployment and low industrial capacity utilization, but their currencies have depreciated relative to the dollar and other currencies.
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