This article has been updated and summarised here
Even before the 2020 pandemic and the subsequent scrambling of central banks and governments to stimulate the economy, interest rates in the UK and US were very low and there were talks at possibly even making them negative. In September of 2019 US President Donald Trump posted a tweet that started with the following sentence the “Federal Reserve should get our interest rates down to zero or less and we should then start to refinance our debt”.
 |
| Photo by Jason Leung on Unsplash |
Conceptually a negative interest rate is not particularly intuitive at first glance – does this mean a borrower is paid to take money? In a typical setting, interest rates effectively are a burden to those borrowing and an incentive to the savers. Do negative interest rates reverse this and can you be rewarded to borrow?
The US and UK are no strangers to low interest rates following on from the 2008 financial crisis the central banks followed the now standard procedure – drop interest rates down to stimulate the economy. In 2007 the Bank of England rate was 5.5% which was lowered in response to the crisis, with the end of 2008 seeing the biggest rates drop in Bank of England history by 4% over 5 months.
Negative rates have already been implemented in Europe and Japan but sceptics on the policy point out that these countries are able to tolerate negative rates on the back of other countries (most notably USA) having a positive rate.
What are interest rates?
Before going into negative rates first let’s cover the system as it currently stands – as we know, interest rates are the percentage of a loan that you pay as a fee for borrowing money. It is also the rate that you receive for saving your money when you deposit said money in a savings account with a financial institution, although the rates are unlikely to equal one another.
Positive interest rates will cost people for borrowing and reward people for saving – but just like individual savers, banks have their own deposits. They deposit, or loan, money to other banks of the overnight market and can chose to hold more than what is legally required.
When an economy is weak the central bank will lower its rate which in turn ought to bring down the inter-bank rate, discouraging banks from saving their money and encouraging them to lend it out as a way to boost business activity and therefore boost the economy.
What happens below zero?
Banks would begin to lose money on their deposits and in theory a negative rate would lead to a negative rates on the overnight market meaning banks would also charge one another for holding their money.
This would have a cascading effect, ultimately finding its way down to impact every savings account within the affected economy. These accounts would plummet to zero and potentially even negative as the banks would be charged to hold money – in reality banks may opt to absorb the costs to avoid scaring away their customers, especially as they could recoup their loses via other products they offer such as insurance and financial instruments.
Whatever the situation, consumers will be discouraged from holding cash on account, as both banks and individuals are incentivised to use their cash there could be heightened business activity as both parties increase spending, investing and lending which is the fundamental goal of such a move.
What do negative interest rates mean for loans?
If the negative rate would bring about a negative inter-bank lending rate, which in theory it ought to, then banks would earn money when they borrow on the overnight market – so a bank could borrow £100 and pay back just over £99 the following day.
 |
| Photo by Eduardo Soares on Unsplash |
The obvious question is why on earth would any lending bank agree to a guaranteed loss of money?
Aside from regulations requiring them to retain cash in the system the simplest explanation for why we might still see activity here is that the cost of holding cash may outweigh the fee of leaving the money with someone else even if you have to pay them since holding an excessive amount of money could increase security fees, wages and even regulatory costs it might make sense for a bank to leave the money at another institution.
Additionally banks using the overnight market are often borrowing money for less than a day and the fees may be negligible if banks frequently switched between lending and borrowing as they tend to do. Whether consumers will be able to borrow at a negative interest rate loan is a different matter.
When it comes to consumer loans commercial banks will always charge an interest rate that is higher than what they pay for their own loans that is after all how they make money. If they can borrow for two percent they'll charge you four percent and if they can get a loan that pays a zero point five percent negative rate they may still charge you a positive one point five percent so while interest rates would fall they may not necessarily fall into the negative range for consumers though it is possible and in fact we've already seen it in Denmark.
Currently being implemented
The story of a Danish bank offering a negative 0.5 percent mortgage certainly turned heads when first announced - you could buy a house and eventually pay back less than what it costs you. Being paid to borrow may sound great incredible but nobody fully understands all the ramifications of negative interest rates.
In principal this makes sense, negative interest rates would boost investing and lending causing inflation. These rising prices would drive the value of the pound down which would make UK goods cheaper to foreign countries providing another boost to demand for goods and services.
These are all things that should increase business activity, employment and wages however we've seen negative interest rates imposed by the Eurozone, Denmark and Japan among other countries but these places struggled with chronically slow growth in deflation when prices fall.
Deflation can be bad as it encourages banks and consumers to hoard their money rather than spend it since a pound tomorrow will be worth more than a pound today this can lead to a vicious cycle and prompt further declines in spending and more deflation. So negative interest rates were seen as a way of discouraging this in encouraging spending
And yet these places still experience low inflation and slow growth despite the negative rates on top of this there are a number of ways in which negative rates could backfire. Negative rates could cause a run on the banks if people opt to physically store their cash rather than keeping it at the banks and paying a fee for it we could also see runaway inflation and even an asset bubble. If mortgages offer negative rates people may begin buying up housing prices to unsustainable levels so it might not even be easier for you to afford a house.
Summary
Negative rates would also hurt savers and income investors as it would mean receiving a low to no yield on bonds or other income instruments in other words those with low risk tolerances may be forced into riskier positions just to maintain their wealth negative rates would also squeeze profit margins for the banks since again they will need to pay for their deposits at the central bank.
Some research even suggests that this has actually decreased lending activity in countries that implemented negative rates since it hurt the banking profits and discouraged lending activity as a whole. However one of the more certain consequences of implementing negative rates now is that it would take away an important lever for the central bank in the future.
Going into the pandemic, employment in the US is high, inflation was close to target and earnings growth, while it had slowed, was still healthy – far from the conditions in the Eurozone, Denmark and Japan.
The Bank of England has already told banks in the UK to prepare for a negative interest rate, and although nobody really knows what will happen in this new age of uncertainty a theory holds that negative interest rates are tolerated economically so long as the US remains above zero.
If the US were to implement such a policy the potential hit to the integrity of the US dollar the global economy may all well outweigh the benefits of a negative interest rate shift.
This article is not
advice and has not been prepared in accordance with legal requirements designed
to promote the independence of investment research – no recommendations are
given in the buying, selling or holding of any investments. Past performance is
not a guide to the future. Investments rise and fall in value so investors
could make a loss.