When one first hears about negative interest rates, it’s almost like the term couldn’t be real. Negative interest rates go against everything we consider to be principles in the time value of money concept – namely that due to compounding interest our money will be worth more in the future.
What do Interest Rates Mean?
But to understand negative interest rates, let’s first dive into what interest rates tell us in general. Interest rates represent the return required for the risk in an investment. Every money market investment from the simplest bank deposit to the most complex financial instruments has risks. As investors, we want to be compensated for that risk, and the compensation is usually described in interest rate terms.
The most fundamental rate in the US is the “risk-free” rate, which is the Federal (Fed) Funds Rate. Why is the Fed Fund Rate risk-free? Well, because today we have a high level of confidence that the US financial system will be functioning tomorrow morning. Forecasting where the financial system might be in two days or three months is much less definitive. It’s like we know the sun will come up tomorrow because it did today, but we can’t be certain about the day after until we see what happens tomorrow.
The types of risks that financial investments can have are endless and include such terms as credit risk, default risk, inflation, and liquidity risk. While risk is rooted in financial mathematics, it basically boils down to one thing – can we get our money back? Since we don’t know for sure, we want some level of risk return.
To arrive at the correct risk return, the market calculates a “risk premium”. The risk premium starts off with the risk-free rate and then adds every risk identified for that investment. To illustrate, if investment A requires a 10% return, and investment B requires a 5% return, we can assume investment A is riskier than investment B. If the risk-free rate is 1%, then the risk premium for A and B is 9% and 4% respectively.
What do Negative Interest Rates Mean?
Effectively negative interest rates mean that not only will we not get compensated for our risk, but we will have to pay a risk premium for making the investment. Think about that for a moment – not only are we not guaranteed to get our money back, but we now also have to pay for the privilege of making the investment.
There are other ways to look at the concept but another example would be to assume that if we make a bank deposit for $1000 today, with a negative interest rate of 10% we’d have to pay the bank $100 to keep our deposit with them.
Are Negative Interest Rates Real?
Yes, they are very real. To most ordinary people, “interest rates” means the borrowing rates paid on things like mortgages, car loans or credit cards. With some exceptions in home mortgages in Scandinavia, those rates are still positive.
The major exception is in government bonds. The yield on government bonds across the developed world has been very low or dropping for years. Today, the central banks of Denmark, Sweden, Switzerland, Japan, and the European Central Bank (ECB) have zero or negative interest rates in one form or another. Why? It’s simple. To stimulate their lagging economies.
The general rule is that when inflation is high, interest rates are high. Consequently, when inflation is low, interest rates are low. High inflation requires a control valve to lower that inflation, and what better way to decrease demand than with high-interest rates on borrowing. When we have deflation, and we want to stimulate the economy, one way is to increase demand by making money cheap with low-interest rates. Increased inflation translates to higher GDP, jobs, and prices.
So Where are the Issues?
The first and most obvious issue is that negative interest rates do nothing to change the fundamentals in an economy. Central banks have never been capable of changing macroeconomic fundamentals. As powerful as the Federal Reserve is in steering, their ability to change the US back to a manufacturing based economy is almost non-existent.
The second issue is that negative rates are costly and could almost certainly become permanent. Keynesian economics of government deficit spending is supposed to be a short-term stimulus to help end a recession or depression, but over the last 40 years has become permanent policy – no political party ever wants to reduce spending and lose jobs. Raising interest rates would mean job losses.
Finally, on a global level, negative interest rates impact foreign exchange rates in ways that could lead to a currency war of competitive devaluations. Globally, we already teeter on a delicate currency competition. A weak US Dollar means more exports, which mean more US jobs – but if every country devalues their currency to increase imports, then everyone loses.
Could Negative Interest Rates Ever Happen in the US?
Depending on who is speaking, negative interest rates are considered a necessary strategic stimulus or act of desperation. Judging by the European and Japanese model, which has experienced some success, implementing negative interest rates are a very real possibility. The Federal Reserve has considered it several times, albeit at an academic level, and they have publicly stated that while it is an approach they would like to avoid, nothing is out of consideration to prevent a recession backslide in the US economy.
Dr. Alfred Sanders is a professor of finance at the Jack Welch Management Institute, and a Partner, Capital Markets Consulting at Genpact.