Wednesday, September 25, 2019

A Primer on Negative Interest Rates (Part 1)

Click here to read the original Cautious Optimism Facebook post with comments

5 MIN READ - Given CO’s recent spate of posts on negative interest rates, the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff takes a brief diversion away from his series on Healthcare in America to address the recent unorthodox monetary policy.

Recently we’ve read a lot about negative interest rates in the news. Statistics abound about $15+ trillion in worldwide sovereign debt trading at negative yields. Alan Greenspan predicts negative interest rates on U.S. Treasuries are a fait-accompli. Other articles focus more closely on global central bank negative interest rate policy and predictions swirl that commercial banks will soon start paying borrowers to take out loans.

The purpose of this article is to define clearly what negative interest rate policy is, how it works, and to differentiate explicit negative rate policy from central banks from its spinoff effects, such as falling yields on government debt which are more an aftereffect than direct policy itself.


First of all, where does the explicit policy originate from? The answer is simple: central banks.

In the fallout of the 2008 global financial crisis and global recession, many developed economies in Europe plus Japan have spent a decade crawling out of the slump plagued by extremely slow economic growth and subpar recoveries. While governments argued over fiscal policy—some calling for deficit spending, some for austerity, most spending and taxing more and calling it “austerity”—central banks have tried to pick up the perceived slack with monetary policy.

For the first several years of the tepid recovery, central banks the world over engaged in quantitative easing (massive securities purchases paid for with freshly printed reserves to load banks up with loanable funds) and zero interest rate targeting in the hope that businesses would be lured into borrowing on the cheap and banks would lend more generously. The belief was that the newly manufactured credit would stimulate recovery.

Central banks have also been obsessed with reaching inflation targets (usually somewhere around 2%) in the belief that inflation is necessary to stimulate credit and spending (both consumer and business) since someone who believes his money will be worth less tomorrow is more likely to spend, invest it, or borrow more today.

Central banks also want to jumpstart inflation to dilute the real value of their government's debts, although they will never publicly say so.

However if banks aren’t in a generous lending mood, all those QE reserves will do little to spur inflation since the broader money supply grows only when banks lend and increase their customers’ demand deposit balances.

Now the Economics Correspondent believes the entire premise of stimulating credit and 2% inflation targets is fallacious from the start—which may explain why the more countries have pushed interest rates down and used more and more radical means to stimulate lending the more disappointed they’ve been with the lethargic results. However the debate over how effective stimulative monetary policy and inflation are towards promoting growth can wait for another time. The purpose here is to explain the official justification behind and mechanism of negative rates.

So after years of zero rates and loading banks up with reserves—trillions of dollars more than they are legally required to hold to back up their deposit liabilities—some central banks decided to pursue more radical policies and experimented with negative interest rates.

What does that mean? Well it doesn’t mean (at least not for the foreseeable future) “banks pay retail borrowers to take out loans.” It also very rarely means “banks charge you negative interest on your deposit balances” although European banks may be reluctantly inching closer to that paradigm.

No, the first and most important salvo of negative interest rate policy was for central banks to begin charging their member commercial banks negative rates on idle reserves in excess of those they are required to hold (ie. so-called “excess reserves”).

Banks take deposits from customers (or obtain reserves from the central bank) and, in the United States, are only required to hold approximately 10% of those deposits in reserve while loaning the other 90% out. However if they cautiously choose to lend less and hold more in reserve, any balance above and beyond the 10% reserve requirement is considered “excess reserves” by the central bank.

During the Fed’s QE1, QE2, and QE3 the excess reserve balances of U.S. banks went through the roof: from virtually zero to a peak of $2.5 trillion in late 2014. The crisis-management policy goal at the time was to load banks up with reserves and telegraph a message to nervous depositors that their bank was in no danger of failing due to a bank run since they were holding vast quantities of reserves that could be converted to cash at any time. The huge excess reserve balances also served as an oasis of loanable funds that the Fed would urge or discourage commercial banks to lend or not lend whenever it wanted to stimulate the economy or hit the brakes.

So in light of world central banks becoming frustrated that commercial banks weren’t lending their own excess reserves aggressively enough, monetary policymakers in Europe and Japan began charging negative rates on excess reserve balances: starting at -0.1%.

To a commercial bank, this was a shot across the bow. A bank with, say, $100 billion in excess reserves sitting idle at the ECB knew that a year later it would only have $99.9 billion left, a loss of $100 million which is more than it sounds like when comparing it to the bank’s thinner profit margins. Thus an incentive was produced for the bank to lend more of that $100 billion out at a better interest rate than -0.1%.

After a year or so central banks became more aggressive. The rate on excess reserves was lowered further: to -0.25%, -0.4%, -0.5% and so on. Today the European Central Bank's (ECB) rate on excess reserves is -0.5%. Now the hypothetical bank's $100 billion excess reserve balance loses $500 million a year. The Bank of Japan’s rate on excess reserves is only -0.1%.

(see link for policy analysis of "pain" inflicted on European banks)

The Swedish Riksbank’s so-called deposit rate is a deeper -1.0% and has been negative since 2009 (uncoincidentally Sweden has inflated a new housing bubble). The Swiss National Bank’s so-called “sight deposit” rate is -0.75%. Denmark is also employing negative interest rate policy. Switzerland, Sweden, and Denmark all use their own currencies and don’t operate in the Eurozone common currency area.

Incidentally some news articles have reported that negative rate policy is designed to compel consumers and businesses to spend more. That’s mostly incorrect. The objective of negative rate policy is overwhelmingly to compel member commercial banks to lend more. While zero or near zero interest rates on savings and deposit accounts might motivate consumers and businesses to spend a little more, effectively positive rates won’t boost spending much and hardly to the levels that would result from charging retail and business bank customers a negative rate—something we haven’t commonly seen for reasons we’ll cover in Part 2.


The results of negative rate policy are mixed, but generally pretty poor. Policymakers in Europe in particular are having an increasingly difficult time justifying the procedure—especially in Germany, a nation of savers with a longstanding distrust of inflationary monetary policies.

One of the pitfalls of negative rate policy is that commercial banks might make riskier loans than they otherwise would—which increases the chance of defaults and possibly even crisis later. Ironically, should such a crisis occur politicians will automatically blame banks for lowering their lending standards.

The opposite risk is that banks may be reluctant to lend at superlow rates to what they perceive as risky borrowers and will elect instead to eat the negative rate—ie. make fewer loans or not lend at all since they can't charge a premium to compensate for the added risk. Monetary policy observers believe this calculus is already in play.

Banks may also choose to use their reserves to buy existing debt instruments instead—a form of lending only that it’s not new lending—and the newly injected money will simply spill over into asset markets, as it has in Sweden which is now experiencing a new housing bubble and the entire globe which is witnessing the makings of a sovereign debt bubble.

Austrian and classical economists have complained for a century that central banks forcing interest rates down artificially, unbacked by real public savings (ie. actual deferral of consumption), distorts economic calculation and misleads entrepreneurs into embarking on long-term debt-fueled business ventures for which inadequate saved resources actually exist. Negative interest rates, they argue, only distort coordination of saving and investment further.

Central bank governors the world over have complained that growth isn’t really picking up in their countries and vowed to do “whatever it takes” to stimulate more lending. Hence negative rates on excess reserves have gone lower and lower. Yet they are pushing further into uncharted territory and have no historical guide to properly assess the risks they’re creating with such radical policies.


In the United States, the Federal Reserve has not implemented negative rates and it’s still very far away from doing so. Just last week the Fed cut its interbank lending rate to 1.75%—still very positive—and even the IOER (interest on excess reserves) rate only recently fell to +1.8%.

However the Fed does reserve the right to implement negative rates if it feels necessary. Most experts believe that would be in the aftermath of another deep recession like 2008-09. In fact Janet Yellen addressed the subject near the end of her term as Fed Chairperson before Congress, testifying that the Fed had no intention of enacting negative rate policy anytime soon but might consider it in a future slump if the governors felt all other policies were proving ineffective (see link for more info).

In Part 2 we’ll discuss what negative interest rate policy means for commercial bank customers (retail and business) and government debt markets.

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