FRANKFURT Global interest rates are likely to go even lower before they rise as financial market volatility and the specter of deflation raise fresh doubts about central banks' ability to fulfill their mandates, policymakers and economists said.
With markets in turmoil and talk of further Chinese currency devaluation intensifying, expectations for U.S. rate hikes this year have all but evaporated and central banks from Europe to Canada and Australia are preparing the ground for more easing.
Faltering emerging market growth is exacerbating concerns, raising the risk that policy easing in too many places at once will cancel itself out and force national banks into a vicious cycle of competitive currency devaluation.
"The biggest risk for the world economy at this point is an aggressive policy of devaluation in China," said the head of a major central bank in Europe, who asked not to be named.
"With uncertainty and volatility already high, it would have a big consequence for all economies."
The People's Bank of China has been fighting to keep the yuan stable since Jan. 6, when its second sharp depreciation in six months sparked fears of more devaluation as growth in the world's second biggest economy, already at a 25-year low, slows.
Chinese stocks .SSEC have lost over a fifth of their value since the start of the year, while a renewed slide in oil prices, a major indicator of economic activity, took Brent crude to its lowest since 2003. The CBOE Volatility Index .VIX, the U.S. equity market's "fear gauge" has risen sharply.
The European Central Bank responded by raising the prospect of another rate cut in March while the Bank of England has rowed back from suggestions it could start hiking rates soon.
Last week, the Bank of Japan unexpectedly lowered its key rate into negative territory, abandoning its policy of holding rates at zero to avoid potential damage to the financial system.
"The BOJ provides the strongest signal to date that the previously assumed zero lower bound on rates is no longer valid," Deutsche Bank strategist George Saravelos said.
"Markets should now be pricing that global rates across global fixed income can sustainably and substantially trade below zero in the current and future easing cycles."
Money markets now see the ECB's deposit rate sinking to -0.5 percent this year from -0.3 percent ECBWATCH while the BOJ said its policies provided room for more easing if needed.
The Reserve Bank of Australia, the Bank of Canada and Sweden's Riksbank have also highlighted risks, keeping the possibility of policy easing on the agenda.
The U.S. Federal Reserve has been the big exception, lifting interest rates in December for the first time since 2006, but has already acknowledged headwinds that may delay further hikes.
"It is difficult to judge the likely implications of this volatility," Vice Chairman Stanley Fischer said on Monday. "If these developments lead to a persistent tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States."
San Francisco Fed President John Williams meanwhile said the next rate rise may need to be delayed somewhat.
Traders now see only one increase if any this year, probably in November, not the three or four discussed in December. Odds have shifted quickly, so any more market volatility could erase rate hike expectations for 2016.
The problem for central banks is that their tools in a zero-rate environment are relatively untested, only moderately effective and, because they do not coordinate policy, prone to cancelling each other out.
Returns from quantitative easing diminish with each round while deeply negative rates raise financial stability risks as banking profitability falters and asset bubbles form.
Currency depreciation, a key policy transmission channel for most central banks, also has limits as too many countries trying to devalue leads to a currency war.
"The economic bang for the depreciating buck, or yen or euro is relatively small," Citi economists Steve Englander and Josh O’Byrne said in a note to clients.
"A consequence is that if the exchange rate is the tool of monetary policy, it doesn't work nearly as well as advertised, you have to go much further than you think, for much longer than you think and you are probably in much deeper trouble than you are willing to admit."
Neither does policy easing solve the underlying problem of high debt, which is holding back growth and inflation.
One source with knowledge of the ECB's thinking acknowledged that its room for maneuver is limited: "We have a lot of tools still but all are problematic one way or another so they are not the most effective."
Central banks are nevertheless compelled to act by their unique mandates, which mostly set targets for inflation.
ECB President Mario Draghi has stressed that the euro zone's central bank focuses on its mandate, a message echoed by BOJ Governor Haruhiko Kuroda who said last week his bank would "do whatever it takes" to achieve its goal.
(Additional reporting by Ann Saphir in San Francisco, Leika Kihara in Tokyo and Francesco Canepa in Frankfurt; Editing by Catherine Evans)