Negative Interest Rates: What Does It Mean?

Can you imagine going to a bank and they said they would pay you if you took out a loan with them? That’s “negative” interest rates. It is ridiculous, counterintuitive but that happens in Sweden, Germany, Denmark, Switzerland and Japan.

From a practical perspective, the mechanics of negative interest rates are clear – borrower agrees to pay USD 1,000 in a year but the lender extends USD 1,020 (or a negative yield of 2%).

Wouldn’t the lender be better of keeping the cash? That’s another story! Standard economic theory would suggest interest rates should be reasonable enough for depositors to save. And low enough for businesses to borrow or invest. Economic theory has no room for negative rates. 

Interest rate is determined by the interaction of borrowers and lenders. Interest rates rise if there are more borrowers seeking funds than depositors (or savers). And borrowers are willing to pay for scarce funds. The converse is also true.

The interventions of central banks (especially the Fed, The European Central Bank and the Bank of Japan) have been very active since the financial crash of 2008. The Fed, under Chairman Powell, made a good faith effort over the last two years to get out of the business of suppressing interest rates. But the global efforts of the European Central and the Bank of Japan were in the opposite direction. Suppressing interest rates by them have put the Fed in an untenable position. Last month the Fed responded by cutting interest rates and signaling that more cuts might be coming. Despite eleven years of economic growth, we are back to a world of low interest rates and negative interest rates in much of the developed world. Central banks turn to them in the first place to stimulate inflation (Japan is an example) and defend currencies (Denmark and Switzerland). The effects of which were property prices rose; contradicted monetary policy and savers still saved.

Where do we go from here? No one knows. The hyperactivity of central banks has had some long-term damaging influences. Government debt has ballooned out of control, without the discipline of realistic interest rates to temper political ambitions. Corporate debt has also climbed to new heights. Low interest rates encourage companies to borrow cheap funds and buyback their own stock instead of paying workers higher wages. The world has learned how to manipulate fiat money for short term advantages. With the “quantitative-easing cat” out of the bag, populist like Bernie Sanders can just print money to finance healthcare, student loans and other popular schemes.

It will be a long and difficult road back to the inevitable reality that the world is not flat and that true purchasing power is represented by money earned and not just printed. In the meantime, it might not be a bad idea to buy a little gold and borrow for a good investment.

Reference:

1.     Gordon C. Boronow, Op-Ed Contributor, Negative interest rates? How does that work?, 27 August 2019;

2.     Reuters, Explainer: How does negative interest rates policy work? 13^th September 2019;

3.     Daniel Straus, Business Insider, Trump has ramped up calls for negative interest rates. Here’s what they are and why they matter, 11^th September 2019;

4.     Chris Carosa, Forbes, What are “Negative’ Interest Rates and How Can You Make Money From Them?, 20^th August 2019

5.     Alex Graham, Analyzing the Effects of Negative Interest Rates Across Five Economies, https://www.toptal.com/finance/market-research-analysts/effects-of-negative-interest-rates