Last Thursday, the European Central Bank (ECB) cut its deposit interest rate from -0.3% to -0.4% and ramped up its quantitative easing measures by increasing its monthly bond purchases from €60 billion to €80 billion (including corporate bonds now) in what seems like a last-ditch effort to combat deflation.
This move was highly aggressive – and highly unexpected, but it wasn’t the first negative rate cut to come out of left field in 2016: in January, the Bank of Japan surprised everyone by adopting a negative interest rate policy, cutting its deposit rate from 0% to -0.1%.
Now 2 major economies (the ECB and the Bank of Japan) and 3 other national banks (the Swiss National Bank, the Swedish National Bank, and the Danish National Bank) have adopted negative interest rate policies.
Today, 30% of all bonds globally (over $7 trillion worth) yield negative rates, up from <10% in 2015 and virtually 0% before 2014. Federal Reserve Chairwoman Janet Yellen even indicated that the United Sates could very well see negative interest rates, if warranted.
It seems clear at this point that negative interest rates are here to stay.
But what even are negative interest rates?
Moreover, how do negative interest rates work? Why do central bankers think negative interest rates are a good idea? And does this mean that banks are going to start charging negative interest rates on deposit accounts and mortgages?
Well, let’s find out.
LENDING AND BORROWING
Negative interest rates don’t make any intuitive sense.
At some point in your life, you have probably let a family member, spouse, best friend, co-worker, acquaintance, or stranger borrow something of yours – whether it was a pencil, a dress, or a car.
In some instances, you probably expected something in return – e.g. a favor in return or even just a verbal “thank you.” In other instances, you might not have required anything in return – all you expected was to get the item back in the same condition as before.
For example, if you let your neighbor borrow your car for an emergency, you would probably expect the car to be returned in mint condition as well as a thank you note. But if you let your best friend borrow a pencil in class, you might only expect the pencil to be returned (hopefully without chew marks).
This is the same way lending money and borrowing money works. You lend money out and you get interest and principal (i.e. the original amount lent out) back. Sometimes the interest rate is high, sometimes it’s low. Sometimes there is no interest rate at all. But under no circumstance would you ever lend money and expect to have a negative return – that is, never would you lend money and expect to receive less money in the future.
Just liked you’d be unhappy if you lent your neighbor your car and he crashed it, or you lent your best friend a pencil in class and she gave it back to you with chew marks on it, you’d be very unhappy if you lent somebody $100 and only got back $90.
But this is essentially what is happening with negative interest rates.
Negative interest rates are counterintuitive to the natural expectations we have when lending and borrowing.
With negative interest rates, you are literally paying someone to take your money.
Imagine if you went outside right now and offered the first person you saw $100 if he or she borrowed your car for the day. People would think you were crazy.
This is what I mean when I say that negative interest rates don’t make any intuitive
sense, and why a negative interest rate policy is considered to be so radical.
But in reality, negative interest rates aren’t all that crazy. And if you have a checking or savings account at a bank or have cash in your wallet, you are essentially being charged a negative interest rate right now.
Before I get to that, let’s first review why central banks change interest rates in the first place.
WHY CENTRAL BANKS CHANGE INTEREST RATES IN THE FIRST PLACE
The Federal Reserve (the central bank of the United States) was established by Congress to (i) maximize employment and (ii) stabilize prices. This translates into a targeted unemployment rate of ~4.7%-5.8% (depending on a number of factors) and a target inflation rate of 2%. The main task of the ECB (the European Union’s central bank) is to maintain price stability (i.e. inflation of just under 2%). Other central banks have similar mandates.
Monetary policy refers to the actions that central banks undertake to influence the amount of money and credit in the economy in order to achieve their mandates. Central banks have 3 main tools that they can use to influence monetary policy:
- Open-Market Operations
- Setting the Discount Rate
- Setting Reserve Requirements
I’ll focus mostly on the discount rate here since we’re talking about interest rates, and I’ll use the U.S. Federal Reserve as a framework for all central banks (even though the Fed hasn’t yet ventured into negative rate territory).
How Commercial Banks and the Federal Reserve Work
Just like families and businesses have accounts at commercial banks (e.g. Bank of America, Wells Fargo), commercial banks also have accounts at the Federal Reserve. This is where the commercial bank holds its reserves – the money it is not allowed to lend out and must keep at the central bank. Think of the reserves as a safety net in case there is a financial crises or distress in the economy; having reserves on hand would help the commercial bank deal with a bank run and would keep it solvent.
In the U.S., large commercial banks must keep 10% of their deposits as reserves in the central bank. This is the minimum amount. Some days, because of the lending and borrowing activities of that particular day, a commercial bank will have less reserves than is required or it will have more reserves than are required (“excess reserves”). If a commercial bank has excess reserves, it can lend that money to another commercial bank that has less reserves than are required via a loan of electronic cash overnight. This is the simplest, shortest loan in the economy and the interest rate for this type of loan is called the “federal funds rate.”
The Federal Reserve can’t choose the rate at which commercial banks lend to each other – the fed funds rate – but it does have the ability to indirectly influence the fed funds rate by setting the “Federal discount rate” and the “deposit rate.”
When a commercial bank needs additional reserves but can’t borrow from another commercial bank because it is uncreditworthy, the Federal Reserve will step in and act as a “lender of last resort.” The interest rate that the Fed charges is called the Federal discount rate (or just the discount rate for short). The discount rate set by the Fed is currently 1%. This sets an upper limit for the fed funds rate, because no commercial bank would borrow from another commercial bank at >1% if it can just borrow from the Federal Reserve at 1%.
The Federal Reserve also pays interest on reserves – both required and excess – that are kept at the Fed. Currently, this “deposit rate” is 0.5%. This sets a lower bound for the fed funds rate, because no commercial bank would lend to another commercial bank at <0.5% if it can just keep its excess reserves at the Fed and earn 0.5%.
So in summary:
- Federal discount rate: This is the rate at which commercial banks can borrow from the Fed. The Federal Reserve has set this at 1%. The ECB calls this rate the Marginal Lending Rate and it is currently set at 0.25%.
- Deposit rate: This is the interest rate that the Fed pays on commercial banks’ required and excess reserves held at the Fed. The Federal Reserve has set this at 0.5%. The ECB has set this at -0.4%.
- Federal funds rate: This is the rate at which commercial banks borrow and lend excess reserves to one another; the upper bound is the discount rate and the lower bound is the deposit rate. The Federal Reserve has set a 0.25% – 0.5% target for this rate; currently it is 0.5%. The ECB calls this the Main Refinancing Rate and it is currently 0%.
The fed funds rate is the most important rate in the economy because this rate affects all other interest rates (prime rate, LIBOR, checking accounts, mortgages, business loans). Banks that borrow funds at low interest rates can pass this lower cost of debt on to consumers who have mortgages, auto loans, or credit cards. In a lower interest rate environment, businesses are more likely to undertake capital investments such as expansion of facilities or machinery, both of which stimulate employment. The lower cost of debt to businesses also encourages expansion and keeps them from behaving too conservatively in times of weak economic growth.
Again, it’s worth noting here that the discount rate and the deposit rate set upper and lower bounds for the fed funds rate. The fed funds rate itself is affected by the supply and demand of money in circulation. Therefore, central banks also use open market operations and (to a lesser extent) the required reserve ratio to affect the supply and demand of money in circulation. With open market operations, the central bank buys and sells government securities in the open market: when the central bank buys securities, it pays in cash thereby increasing the money supply; when it sells securities, it receives cash thereby reducing the money supply).
Check out America’s Bank: The Epic Struggle to Create the Federal Reserve by Roger Lowenstein if you want to learn more about the Federal Reserve.
THE ZERO LOWER BOUND
Central bankers used to talk about there being a “zero lower bound” to the fed funds rate. No one would ever lend money at a negative interest rate, right? So the fed funds rate could never be below zero. This was considered to be a very serious macroeconomic problem. If the fed funds rate is already at 0%, and an economic crises hits, then the central bank is unable to jump-start the economy by lowering interest rates because interest rates are already as low as possible. This causes a liquidity trap, and the economy enters into a prolonged recession.
This is why the Fed started “quantitative easing” following the 2007-2008 financial crisis. The fed funds rate was already near the zero lower bound, so none of the traditional monetary policy tools could have an effect.
Quantitative easing (QE) is basically like open market operations (OMO), but it involves purchasing massive amounts of short-term and long-term debt (whereas OMO restricts itself to smaller amounts of short-term government securities). So, a central bank can affect both short-term and long-term interest rates, instead of just short-term interest rates. At the same time, it injects massive amounts of money into the system, boosting asset prices and helping banks extend credit.
Although controversial, QE was considered to be effective in the United State, so quantitative easing measures have been implemented by the ECB and the Bank of Japan to help kick-start their respective economies. However, it doesn’t seem to be working too well, as economic growth remains low in both the eurozone and Japan.
In the eurozone, inflation remains well below the target of just under 2%. In fact, consumer prices fell 0.2% year-over-year in February 2016. Meanwhile, Japan has been battling falling consumer prices and zero economic growth for a decade. Falling consumer prices is called deflation and central bankers are terrified of it.
WHY CENTRAL BANKS ARE DEATHLY AFRAID OF DEFLATION
You might be thinking, “Aren’t falling prices good?” Lower prices mean cheaper food, cheaper iPhones, and cheaper rent, which means you could buy more stuff.
It’s true that decreasing prices for some things can be good. For example, the decline in oil prices in 2014 was considered to be a “net” good thing for the economy, because it left more room in companies’ and consumers’ budgets to spend.
But if prices drop across a wide range of goods for a sustained period of time, economic activity comes screeching to a halt (note: energy prices – including oil – are usually excluded from most measures of inflation anyways).
Why does deflation cause economic activity to come screeching to a halt?
Deflation occurs when the supply of goods is greater than the demand for goods (for example, because of a decrease in the money supply, lack of credit, or weak consumer spending). When there is an excess supply of goods, companies are forced to cut prices, which reduces profits and means they have less money for capital investments and hiring. This means that wages stagnate and consumers spend even less, driving prices down even more. Even companies and household who want to spend will likely hold off, because declining prices mean that goods will be cheaper tomorrow than today. Lower profits, lower wages, and lower spending also translate into reduced tax payments, which lowers government spending and reduces economic growth.
Deflation fueled two of the worst economic disasters in modern times — the Great Depression of the 1930s and Japan’s lost decades (the country has had almost no economic growth since 1991).
“If inflation is the genie,” IMF Managing Director Christine Lagarde warned in January 2014, “then deflation is the ogre that must be fought decisively.”
Conversely, hyperinflation is also extremely terrifying. Hyperinflation is when the monthly inflation rate is greater than 50%. At a monthly rate of 50%, an item that cost $1 on January 1 would cost $130 on January 1 of the following year. At this point, saving money stops and the notion of currency – and having an economy in general – becomes a joke.
This is why central banks like moderate inflation. Moderate inflation gives a central bank room to boost the economy when it is slowing down and cool the economy off when it becomes too hot. Also, good inflation is usually driven by things like increased consumer spending and higher wages. In general, a moderate level of inflation is a signal of a healthy economy.
WHY CENTRAL BANKS HAVE RESORTED TO NEGATIVE INTEREST RATES
This was the conundrum the ECB was facing when it first implemented negative interest rates in 2014 and when it decided to cut rates further last week; and that the Bank of Japan was facing when it first implemented negative interest rates in January 2016:
- Deflation looks like it’s knocking on the door, which would derail any chance of an economic recovery.
- However, interest rates were already extremely low – at or near the zero lower bound, which means that standard monetary tools are ineffective.
- So, since 2014, the ECB has relied on a combination of non-standard monetary policy tools – negative interest rates and quantitative easing; and the Bank of Japan has been relying on massive amounts of quantitative easing (part of its Abenomics policies) since 2009.
- However, even these non-standard tools have been not been able to spark inflation and economic growth.
Why have quantitative easing and low interest rates been ineffective?
I mentioned earlier that deflation is caused when the supply of goods exceeds the demand for goods. Excess supply/low demand itself can be caused by a decrease in the money supply, a lack of credit, and/or weak consumer spending. While quantitative easing serves to increase the money supply, the eurozone is still suffering from the other two causes – weak consumer spending and a lack of credit.
Weak consumer spending is easy to understand, what with elevated unemployment, limited wage growth, and high levels of uncertainty in Europe and Japan.
But what about the lack of credit?
Following the start of the European debt crisis in 2009 – when Greece, Portugal, Ireland, Spain, and Cypris were unable to repay or refinance their government debt – eurozone banks have been too scared to lend to each other. So the ECB set the marginal lending rate very low, allowing banks to borrow cheaply from the central bank and increasing the money supply. Then the ECB started quantitative easing in March 2015; with QE, the ECB buys bonds and pays in cash, which also increases the money supply.
An increase in the money supply is supposed to increase lending, drive up investments in other assets like factories and stocks, and increase inflation. However, low interest rates and quantitative easing haven’t been effective because European banks are hoarding this extra cash instead of lending it out to businesses and consumers.
This is why the ECB and the Bank of Japan have now resorted to negative interest rates.
Every time a commercial bank borrows from the central bank, the central bank credits the commercial bank’s account and more reserves are created. Every time the ECB buys a bond in the open market, it also credits the reserve account of the bank whose customer was the seller. The result is a surplus of reserves.
So the solution seems simple: charge banks on their extra reserves. Theoretically, this would induce the banks to get rid of their excess reserves by lending them to other banks. This competition pushes down the overnight rate, which drags down all other rates – rates on credit cards, mortgages, business loans, bonds, etc. – which results in more capital investment, increased hiring, bigger wages, higher inflation, and a stronger economy. [An important point here: Banks don’t lend excess reserves directly to consumers. The reserve system is more or less a closed loop. Banks lend excess reserves to other banks. When more banks lend their excess reserves, there is more competition – this lowers the overnight rate, which in turn drags down all other rates.]
Moreover, lower interest rates would decrease the short-term demand for the Euro, since Euro-denominated bonds and stocks now have lower returns than, say, a U.S. dollar-denominated stock or bond. This causes the Euro to depreciate, which means that European goods become cheaper for buyers in China or the United States, which increases European exports – further enhancing eurozone economic growth.
The central bank can essentially charge commercial banks that hoard the extra cash that is being pumped into the system through QE by charging a negative interest rate on excess reserves.
HOW DO NEGATIVE INTEREST RATES ACTUALLY WORK?
Remember, central banks influence the rate at which commercial banks lend excess reserves to each other overnight (the fed funds rate in the U.S. or the main refinancing rate in Europe) by setting the upper bound discount rate (marginal lending rate) and the lower bound deposit rate.
It is the lower bound – the deposit rate – in Europe and Japan that is now negative. In Europe, the deposit rate is now -0.4% and in Japan it is -0.1%.
Essentially, commercial banks must now pay the ECB or Bank of Japan if they want to hold on to excess reserves. The negative interest rates cause the electronic balances in reserve accounts of commercial banks to shrink. A deposit of €10,000 at the ECB today is €9,999.92 tomorrow.
This incentivizes commercial banks to lend their excess reserves to other banks, which lowers overnight loan rates, 1-month interbank loan rates, 3-month interbank loan rates, etc. – which in turn lowers the interest rates that business and consumers are charged. The low interest rates, combined with massive quantitative easing, also drives the demand for low-risk, cash-like securities – such as short-term German bonds. This is driving yields on some government bonds negative (currently 30% of all government debt globally have negative yields).
If you still don’t understand how negative interest rates work, then nothing beats a good comic – this one is from Bloomberg:
WHY ARE PEOPLE SO CONCERNED ABOUT NEGATIVE INTEREST RATE POLICY?
In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans.
In practice, however, negative interest rates haven’t been around long enough to really determine if they work or not. The eurozone became the first major economy to implement a negative interest rate policy when the ECB did so in mid-2014 (the Swedish, Danish, and Swiss National Banks had done so before the ECB, but their economies are much smaller and their reason was for foreign exchange purposes – not to stimulate inflation).
So far, there haven’t been sharp turnarounds in the countries that have tried negative rates. Economic growth in the eurozone last year was 1.5%, which was better than the 0.9% recorded in 2014. But as the WSJ points out, growth appears to be tailing off. In the fourth quarter of last year, the eurozone grew at an annualized rate of 1.1%.
Eurozone banks, meanwhile, have begun to lend more to households and businesses. Such lending had been shrinking since 2012 but grew 0.6% in 2015 – a positive sign, but far from robust.
In any case, it’s impossible to know whether things might have been much worse had the countries not tried negative rates.
Additionally, the riskiness of negative interest rates rises the lower rates go:
- Right now, interest rates are only slightly negative, so it’s easier just to pay the negative interest rather than withdraw your money, put it in a vault, and hire guards to watch it. Going back to the car example, at face value it sounds crazy if you went outside and paid the first person you saw $100 to borrow your car for the day (i.e. paying negative interest rates). But what if parking garages are charging $200 per day (i.e. paying to put your cash in a vault)? Wear and tear on the car aside, now it make sense to pay someone to drive around in your car all day. At some point, however, you reach break-even, and then the equation flips. If interest rates go lower, households and businesses will pull their money from banks and put it under the mattress or in vaults, resulting in a credit crunch and recession.
- If banks absorb the cost of negative rates themselves, that squeezes the net interest rate margin (i.e. the profit) that banks make on the spread between their lending and deposit rates, which could make them even less willing to lend. This also results in a credit crunch and recession.
- Just like the zero bound makes standard monetary policy ineffective, central banks will run out of firepower to stimulate the economy the lower interest rates go.
The Bank for International Settlements recently warned in a March 2016 report of “great uncertainty” if rates stay negative for a prolonged period. And because negative interest rates result in domestic currency devaluation which boosts exports, if more and more central banks use negative rates as a stimulus tool, there’s concern the policy might ultimately lead to a currency war of competitive devaluations.
NEGATIVE BOND YIELDS
Because of the threat of a bank run if consumers are charged negative interest rates, it’s highly unlikely that we’ll see negative interest rates on our checking accounts or on mortgages. However, we are seeing negative bond yields – approximately 30% of all government bonds globally now have negative yields.
A negative yield means a guaranteed loss if you hold it to maturity.
Why would anyone buy a bond with a negative yield?
Well most government bonds are incredibly low risk and are almost like cash. Take Switzerland and Germany, for example, both of which have sold government bonds with negative yields. Both of these countries have AAA debt ratings, the highest credit rating a borrower can receive.
Because these bonds are so safe but there is a lot of economic uncertainty, demand is very high and investors are willing to pay a premium for them (i.e. investors are willing to pay >$1,000 for a bond with a face value of $1,000). This drives down the yield. If you pay too much of a premium on a bond, then the yield becomes negative. Some investors have also bought these bonds because they expected further stimulus from the ECB. This would cause the prices of these bonds to rise, and the investors could sell at a profit.
It’s important to realize the difference here between negative yields and negative interest rates. Unlike the deposits at central banks, bonds really have two interest rates – the coupon rate and the yield-to-maturity. The coupon rate is the actual interest payment that a bondholder receives annually or semi-annually. The yield-to-maturity (YTM) is the actual rate of return that a investor would earn, taking into account the initial price paid, the face value of the bond, the maturity (length) of the bond, and the size and frequency of the coupon payments. It is the YTM that is negative on these bonds – not the coupon payment. The YTM is negative because investors are willing to pay a premium for the bonds. If the coupon payment was negative, the buyer would have to make interest payments to Switzerland or Germany, which obviously wouldn’t make sense.
NOMINAL INTEREST RATES VS. REAL INTEREST RATES
In case you’re still wondering why anyone would willingly buy a bond with a negative yield, I want to mention the difference between nominal interest rates and real interest rates.
Nominal interest rates are the interest rates we read and hear about it everyday. Real interest rates are nominal interest rates, but adjusted for inflation.
In a simplified version of the Fisher Equation: Real interest rate = Nominal interest rate – inflation rate.
So if a bond yields 8% but inflation is 2%, then the real interest rate on that bond is only 6%.
If you have a checking or savings account (where nominal interest rate are virtually 0%) or are holding onto cash (where the nominal interest rate is exactly 0%), then the real interest rate is negative because of inflation. This is really not that uncommon when you combine low interest rate-bearing securities and economies with moderate-to-high inflation.
So if you think about it, negative real yields aren’t all that shocking. In the end, negative nominal yields and negative nominal interest rates are what happens when you have very low inflation or deflation.
- Europe and Japan are trying to fight off deflation (falling consumer prices), which would send their economies into recession.
- The ECB and Bank of Japan are running out of effective monetary policy tools, so they have resorted to a Negative Interest Rate Policy.
- This policy is implemented by making the deposit rate negative, effectively charging commercial banks a fee if they want to keep excess reserves with the central bank. The goal is to induce the commercial banks to increase overnight loans to each other, which will lower the cost of debt and will lower all rates in the economy. This will spur economic growth and inflation.
- This loose monetary policy has also caused yields on many government bonds to become negative, because investors are willing to pay a premium for these types of assets – either because they are so safe or because they expect further stimulus measures, which will cause the bonds prices to rise.
Following the 2007-2008 financial crisis, the Federal Reserve initiated its quantitative easing policy. At the time, this was a radical and controversial move and was widely criticized by many economists, politicians, journalists, and investors – both within the U.S. as well as in Europe and Asia. Now, quantitative easing has been implemented by the ECB, the Bank of Japan, the Bank of England, and the Swedish National Bank, and it seems like QE has become a legitimate monetary policy tool.
Today, the roles have been reversed: it is the ECB and the Bank of Japan who are leading the charge on negative interest rates, in the face of much global criticism. Will the U.S. Federal Reserve follow? Will these negative interest rate policies even end up working? Or will they wind up crashing the global economy?
With quantitative easing, the criticism was that the loose monetary policy might create a bubble in risky asset classes. Now, with QE measures being kicked into even higher gear in Europe and Japan, the bubble risk remains, but it has also been compounded by the risks of negative interest rates: (i) that banks will become unprofitable and will stop lending money, and (ii) that central banks are out of options to stimulate the economy.
We don’t yet know if negative interest rates and massive quantitative easing measures will pull Europe and Japan back into prosperity, or if instead the ECB and the Bank of Japan have merely painted themselves into a corner.
I just hope we’ll find out before we have to start burying cash in our backyards.