Negative Interest Rates

Negative Interest Rates

Negative interest rates

For most people the concept of negative interest rates is unusual. Anyone who has had a loan or savings account will be familiar with interest rates, which see the size of their loan or deposit grow each year, or even every day. However, only a few will have experienced a negative interest rate in which the opposite happens.

What are negative interest rates?

In practice, it seems likely most people will never experience negative interest rates. Many central banks are reluctant to use them as a tool. Although they are increasingly discussed, there is mixed evidence about how effective they are, and many countries have used alternative policies. And, for most consumers, even if a central interest rate is negative, it’s likely that the retail rates they access, as either savers or borrowers will remain positive.

Interest rates are, essentially, the cost of borrowing. Whether that’s a customer borrowing from a bank paying interest on their loan, or a bank borrowing from a customer, via a savings account, and the amount they pay to their customer. However, this cost applies to all lending, including the money that retail banks will borrow or deposit with their central bank.

There is a key difference between the rates set by a central bank and a retail bank. A retail bank will set rates largely as a business decision. The interest they charge on a loan will cover not just the cost to them of providing the finance, but also their administration and things like the risk of defaults, as well as to stay competitive. Central banks, however, use interest rates as a policy tool to shape economic activity.

The economic theory behind negative interest rates

A central bank will hope to increase economic activity by lowering interest rates, or dampen economic activity by raising them. Most nations’ central banks will have targets of achieving consistent, moderate growth with low inflation, and interest rates are one of the levers they can use to achieve that. By setting their central rate, they can affect the rates set by retail banks.

Simplistically, when a central bank sets a low interest rate, retail banks can borrow cheaply but get a poorer return on deposits. In turn, consumers have lower loan rates and poorer savings rates, and are therefore incentivized to borrow and spend, powering the economy. The reverse is true when interest rates are high. So, a central bank concerned about an over-heating economy could increase rates, making borrowing more expensive and providing an incentive to save, helping lower spending.

Negative rates, arguably, push that even further. Making lending incredibly attractive — you pay back less than you borrow — while also seeing the value of deposits decrease.

Negative interest rates in practice

The goal of central banks is to balance interest rates and inflation, creating a situation in which they roughly balance each other: a neutral rate. But this theoretical goal has never been sustainably achieved and, with the 2008 financial crisis and the impact of the Covid-19 pandemic, central banks have found themselves spending over a decade implementing policies that are designed to create an economic boost.

The central banks of most major economies slashed interest rates after the 2008 financial crisis and, in most cases, interest rates have remained low ever since. In many places, the rates were set close to zero, which was seen as the floor. This has meant that ‘real’ interest rates have been below zero in many places for over a decade, with the interest rate outstripped by the prevailing rate of inflation. Indeed, for most of the period following the Second World War until the early 1980s negative real interest rates were common. However, there has been a reluctance in many places to set a nominal interest rate below zero.

Instead, most central banks have opted for other options to stimulate growth. The most common is increasing the supply of money in the economy. Commonly known as quantitative easing in Europe, central banks have adopted policies like buying back bonds, driving up their prices and, through that, increasing the liquidity — the amount of currency — within the economy. However, some central banks have had negative interest rates in place for several years.

Countries with negative interest rates

Japan was the first to set a zero-rate interest policy in 1999, breaking the traditional wisdom that rates should always be positive, before setting a negative rate in 2016. Several European countries have also set negative rates, including the European Central Bank (ECB), responsible for the Eurozone.

ECB rates were first negative in 2014, when they were set at -0.1%, going as low as -0.4% before being set at their current zero in 2016. Denmark, Sweden, and Switzerland all set negative rates in 2016, and both Denmark and Switzerland still have negative interest rates of -0.75%.

However, while the Federal Reserve and Bank and England have, so far, kept rates positive — although at record lows — the possibility remains. In February 2021, the Bank of England requested retail banks prepare their systems to deal with negative interest rates within six months, so if they felt it was necessary, they could set a negative rate with minimal disruption.

Strong arguments against negative rates remain, however. The first is the risk to banks since profitability in banking comes, essentially, from the difference between the money they make on lending operations and the cost of their other retail banking operations. The risk of negative interest rates is that the margin shrinks, or even disappears, as banks may be unable to reduce savings rates without losing customers and affecting their liquidity.

Another compelling argument is that the evidence on negative interest rates is mixed. Although the theory may be sound, when implemented the effects have not been quite as clear-cut. When the ECB had negative interest rates it did not appear to have any impact on consumer behavior, suggesting that it offered little or no benefit beyond the low, but still positive, rates that were in place before.

In practice, central banks appear to be reluctant to set negative rates. Instead, they prefer to use other fiscal policies to stimulate the economy, and in Europe, half the central banks that did set negative rates returned to positive rates relatively quickly.

How would negative interest rates affect consumers?

The experience of negative interest rates so far suggests that for most consumers there will be little or no difference between very low interest rates and negative interest rates. While negative interest rates may be a central bank policy, and affect the operations of retail banks, the effects appear to largely lost by the time they get to consumers.

Although lending should, notionally, be cheaper central bank interest rates comprise just a small part of the costs of lending a retail bank recoups through interest. The retail bank will add administration costs, profit, and factor in the risk of defaults which will remain even with negative rates. This means that by the time a consumer is looking at a loan deal the headline rate may be a little lower, but still positive.

Savers are likely to see even less effect. Savings rates are at record lows and are already an unattractive investment. However, banks are likely to be reluctant to reduce rates any further. In a competitive market, where people can easily move their money for even a fraction of a per cent more interest, banks are unlikely to start, effectively, charging customers to hold their money, especially when this would risk their liquidity and create disaffected customers.

There are some examples of negative interest rates being passed onto consumers, but these are the exception rather than the rule. In Germany and Sweden, for example, some high-value customers with large deposits were charged fees, rather than negative interest rates, to offset the cost to the bank. And in Denmark one lender offers a mortgage with a negative interest rate, in which the rate helps pay off the capital. However, generally the experience has been that the consumer just gets slightly lower rates all round.

Indeed, in the UK, the financial regulator has effectively indicated that negative interest deals will not be expected. The rate cuts following the financial crisis excited many people with tracker mortgage deals which fixed their interest rate at a set amount below the Bank of England base rate, who thought they may now be at a negative rate. They were, however, quickly disabused of this notion, with the regulator stating that interest payments were “a one-way obligation on the borrower.” Banks, in other words, would not be expected to pass on negative rates to their existing customers.

The effects may be felt elsewhere, though. If negative rates stimulate additional spending, it’s likely that will have a positive effect on stocks making them a much better alternative for investment than savings accounts. And bonds, which usually have fixed yields, also tend to increase in value since they become much more attractive investments when rates are low or negative.

In practice, it seems, negative interest rates are unlikely to make much difference to consumers. Borrowers may see slightly lower rates, and while savers are probably unlikely to see their returns going any lower, meaning that it’s likely they can get a much better return investing elsewhere.

Expert Contributor:

Zanthe Alexander Bentley is the founder of a suite of investment funds. Owner of Red Hot Penny Shares magazine, the ubiquitous Penny Shares Guide and Sophisticated Investor Magazine, Zanthe has over 25 years’ wealth management experience advising both family offices and institutions on their corporate finance requirements including capital raises (debt & equity), restructurings and M&A activities.

Author of ‘Negative Interest Rates – How to invest safely when banks are paying you nothing.

He has significant experience in investment management and investment banking and spent nine years at UBS focused on convertible bond arbitrage and equity derivatives.

Prior to getting involved in Asset Management he expanded a small Spanish brokerage from a handful of staff in Barcelona to a diversified brokerage company with over 150 personnel spread across 9 countries, transacting deals from High Grade to High Yield Fixed Income and Loans; Structured Products through to exchanged traded equities.

After taking time to focus on family office activities in Asia, Zanthe-Alexander now leads an ambitious zero-leveraged fund providing exceptional growth and income to Sophisticated Investors.

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