Negative Interest Rates for Dummies

If you ever borrowed money, you are most likely familiar with the concept of positive interest rates. That’s the world where you pay interest on the money you borrowed. Lately, you probably been hearing more and more about negative interest rates, where depositors are actually charged to keep their money in an account and borrowers are paid interest on their debt. I admit that the concept of negative interest rates can take a while to sink in. Imagine a bank that pays negative interest.  The common reaction is “Wait, what! Instead of paying interests on my mortgage I’m receiving interests? Why would a bank do that? I don’t follow you…” or the other popular reaction is “If the bank charge me interest on my deposits I’m taking my money out”. Well it hasn’t gone that far, yet.

Negative interest rates are a last ditch effort by a central bank to stimulate the economy by effectively imposing a tax on the excess reserves that banks hold at the central bank. Banks earn interest on the money, called reserves, they park at the central banks, just like savers park money in a bank. In countries where there’s negative interest rate, the banks have so far mostly taken on the cost on holding excess reserves at the central bank.  At the moment, they haven’t pass the cost on to the consumer, out of fear that doing so might spark a bank run. In some cases, in the Denmark, where some homeowners are getting paid interest on their mortgage. In Switzerland, there’s a bank that’s charging clients to hold their deposits. There’s definitely side effects, both positives and negatives.

Why is this happening? The economy is weak and needs a boost. Banks are a pillar of the economy and are not lending as much as they should. Maybe the standards to borrow are too high following the financial crisis. Maybe there is not enough demand. Whatever the case is, banks are keeping excess reserves at the central bank and are receiving interest on them. Theoretically, low interest rate is suppose to stimulate demand for loans and as a result grow the economy. Central banks provide an ample supply of cheap money to banks in order to encourage lending to various individuals and businesses. But that’s not happening. The banks are “hoarding” the money. You are not growing the economy if you have money parked doing nothing. So to stimulate lending and to get these excess reserve out in the real economy, central banks are charging banks for their holdings.

Denmark set negative interest rates as early as 2012, followed by the European Central Bank in 2014. Since then, they’ve been joined by Switzerland, Sweden, Japan, and Hungary. For some, it’s a bid to reinvigorate an economy with other options exhausted. Others want to push foreigners to move their money somewhere else so they can keep their currency down in an attempt to make their exporters competitive. With the European Central Bank trying to “tank” their currency, Sweden and Switzerland responded. Policy makers are also trying to prevent a slide into deflation, or a spiral of falling prices that could derail the recovery. By weakening their currency, they hope to import inflation by making goods coming into the country more expensive, raising domestic prices.

There are other consequences as well. Retirees are feeling the pain as they need income to live on. The days where you could get a guaranteed 5% on your money have been behind for a few years now, but this is something else. Pension plans, insurance companies, retirees, are being driven in riskier asset classes to make up for the loss income. This works in the short-run as long asset prices are increasing, but is not necessary a sound investment policy. In the long-run, who knows what the consequences are? It’s uncharted waters. There are other side effects, Sweden is dealing is a potential housing bubble and people are on a borrowing frenzy. It might ended up badly once rate rises. The best analogy I heard about the dilemma is the joyful feeling of eating McDonald’s right now. It’s delicious in the moment but the perverse effect of eating it will show up later.

Both Canada and the U.S. have their current interest rate at 0.50%. After decreasing them last year Canada just announced they were maintaining their rate. The U.S. are slowly starting to increase them after almost ten years of no increase. There is debate on whether they should go negative. Rates are just above zero, so nobody knows if going negative will actually make a difference. So far the North American central banks are looking at the experience in other countries and will judge the results.

Negative interest rates are a sign of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans to businesses or to weaker lenders. It’s a bid to boost the economy. Is it working? So far the experiment doesn’t prove to be fruitful. Instead of boosting lending like the theory states, banks are taking on the cost which hurt their income, and as a result tighten credit. If banks are not profitable, they don’t lend.  Another perverse effect, banks have been unwilling to pass on negative rates to individual depositors, and have tried to compensate for profits by jacking up mortgage rates, even as headline interest rates fall. These are not the results they were hoping for. Taking such action is suppose to help the economy, not hurt it.

This is where a herd of academics, bankers, analysts and economists are getting in a never ending debate, and the person with the argument that nobody understands usually wins. You get the feeling that nobody knows what they are doing. Falling prices, banks paying you money, it’s a confusing world. I hope this clarifies the insane world of negative interest rate.

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4 thoughts on “Negative Interest Rates for Dummies

  1. I’m actually a Swede so I can fill you in a little.

    Yes, Swedes are borrowing a lot and have done so for at least 10 years now. We had very low prices and are now on the other scale. Stockholm, the capital, is economy is growing 6 % and it’s mainly the service sector that grows. 20-30 % of the population lives in Stockholm and the greater area around. The thing is that we haven’t got the economy less good for over 20 years (since we had our bank crisis during the 90ies). The thing is that the interest rates are so low that it’s very cheap to borrow a lot on your house. The banks however says the borrowers have margins or 4-6 % additional interest rates on the rates that actually are around 2 % today and not 0 % or negative as our central banks has set.

    The main problem on the housing market is that it’s not building enough. Stockholm hasn’t any high buildings and all of the suggestions get chopped in the middle. The politicians don’t do a shit because they are scared of their houses loosing value, but what they have come up with is a law to force people to amortize on their house loan, if the house loan is new. So nobody will move when that’s in place.

    Will be interesting to see what happens. The only way of getting the house “bubble” we have to burst is mass unemployment and no one sees where that should occur. As long as we don’t have a much higher interest rate than ECB 🙂

    Hope you likes the insights and please continue blogging. Really like reading your posts.

  2. Martin,
    Thank you for the insightful reply and comment. It’s good to hear from somebody on the ground. I saw first hand in the U.S. the housing crash and in certain sector of Canada (e.g. Vancouver), prices are so high that they don’t reflect the economic reality. What you mean by amortizing their house loan? Like how many years do you pay your house on,

  3. Yes, I meant how many years you pay your house on. There was a habit of that during the nineties (I’m too young to remember how many years), but it stopped after the IT boom. So the average has been 110 years or something like that. However, there is now a law in the making that will force you on new loans to pay 2 % per year down to 75 % of the loan. Then 1 % down to 50 %. You can’t borrow more than 85 % of the house price either. All of this causes a lock in effect so no one wants to move and that is as you know not good in the long run.

    The solution to all of this is to build more, but not as much so the prices will drop. However, it’s at the moment so expensive that there aren’t any apartments with reasonable rents and the prices to buy is also very high. So the bubble aren’t going anywhere.

    The bank stocks in Sweden are actually cheap if you look on the quality of the bank and the risk you have is if the housing bubble will burst which isn’t likely. SHB is probably the best one since they are growing nicely in the Netherlands and in UK. Well worth for you to have a look on in case you like stabile banks 🙂

  4. I see. Strong regulation usually helps with housing but is often responsible for unforcast consequences. Did you mean that you could have a 110 year mortgage? I’m sorry if I didn’t get that point. If that’s the case, I never heard of it and it sounds insane. I hope I’m wrong.

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