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How strange is a negative interest rate?

29 February 2016, Wealtheon

Written by Hans-Peter van Wersch

Do you imagine having to pay to keep money on your bank account? Despite the idea sounding so strange, the ECB has kept its headline interest rate below zero for almost two years now. In June 2014, the rate was reduced to -0.1%. In September 2014, it fell to -0.2%, while in December 2015, it was lowered once again to -0.3%. This means that if banks want to park their money with the central bank, they need are chargedmoney to do so. The reason why the ECB has done this is to encourage the banks not to keep funds with the ECB, but simply to lend money and so encourageeconomic growth and inflation.

In the past, other countries have also used a negative interest rate. For instance, the Swedish central bank used a negative rate between July 2009 and September 2010 in an attempt to stave off recession after the banking crisis of 2008, before using it again in July 2014. Switzerland introduced its own negative rate in December 2014.

Given that the rates posted by the central bank serve as a benchmark for all other interest rates, a negative interest rate also manifests itself in the effective rates paid on government bonds. At the end of 2015, approximately one-third of the bonds issued by governments in the euro zone had an effective negative yield. This means that, in the end, investors in these government bonds will get less money back than they invested in these bonds.

In the past, negative interest rates have often been used as a ‚Äč‚Äčscientific experiment for economists. Over the course of time, they have become a fact. The question, of course, is do they actually work? Thus far, there is not very much evidence to support them.

Investors can still buy government bonds with an effective negative yield. In doing so, they are aware – and accept – that they will lose guaranteed capital with their investment. The only rational explanation for this is that these investors are expecting deflation to set in so that their money would be worth less, or that they consider an investment in bonds as being more secure than holding on to cash (for instance, a deposit guarantee only covers up to €100,000).

When we look at countries with a negative interest rate, there is very little that points to negative interest rates being the solution for deflation. We can already see that Sweden – which had been struggling with deflation since the beginning of 2015 – has to cope with limited inflation again. On the other side, in Switzerland, deflation continues to be the order of the day, even if the policy on negative interest rates has been in place since the beginning of 2015. In December 2015, prices fell by 1.3% in the land of the Alps, compared with the same month in 2014.

For larger economies, such as the euro zone, inflation continues to be amazingly low at 0.3%, despite a negative interest rate. There is also little to indicate that inflation is likely to rise quickly any time soon. As a consequence, a negative interest would keep working should inflation fall further. However, that all depends on the vague assumption that the banks will pass on these lower rates to the real economy through a sharp rise in granting credit. Whereas until now, the banks have merely cut back on lending, given that the low interest rates on bank loans have pushed their profits down. 

All this is not just the fault of the banks, but of policy in general. To prevent another financial crisis along the lines of 2008 from occurring, the European policy-makers have signed up to the Basel Accords. These agreements state that banks must retain a specific capital buffer, which is higher than it was before the crisis. Ideally, cash resources should contribute to this capital buffer, with loans scoring lower on the bank’s balance sheet. As you will understand, the Basel Accords are certainly no incentive for the banks to issue loans.

The critical question remains of whether ‘monetary’ policy still makes sense as a tool for stimulating the economy when interest rates are at or around the zero mark. At the present time, the opinion of financial experts is that ‘fiscal’ policy - government spending - is a better way of fuelling economic growth. Former US Secretary of the Treasury, Larry Summers, confirmed this recently. Richard Koo, chief economist of Japan’s Nomura Institute, also showed himself to be an advocate of this policy when he spoke recently in the Netherlands. According to both of them, politicians need to do more to stimulate economic growth.

This appears to be the consensus. Let’s hope that it is not too late to put it into practice.

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