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Negative Interest Rates

Negative Interest Rates

It sounds crazy, but a negative interest rate means the lender of a loan is paying interest to the borrower. What a sweet deal! Imagine going into a bank to take out a loan and, instead of paying interest on the money you’re borrowing, the bank pays you interest.

Sounds great. Where do I sign up for one of these loans?
At least for now, commercial banks in the U.S. are not offering loans with negative interest rates to their customers. Negative interest rates are being offered by central banks.

What are “central banks”?
Generally speaking, there are two levels of banks: commercial banks and central banks.  Individuals and businesses do their banking with commercial banks.  Central banks can be thought of as banks for commercial banks.

Central Banks have a long history. The first central bank of modern history, The Bank of England was established in 1694.  In the United States, the first attempt at central banking occurred in the early 1800s, with the creation of the First Bank of the United States and later, the Second Bank of the United States.  Neither of those two attempts survived.  It wasn’t until a severe financial panic in 1907 that the desire for a strong national bank brought the creation of the Federal Reserve System (the “Fed”). Other examples of central banks are “The ECB” (the European Central Bank) and the Bank of Japan (Japan’s Central Bank).

Why should I care about negative interest rates?
World economic growth has been slowing. Countries are having difficulties stimulating their economies. Significant headwinds include disruptive trade wars, depopulation, shrinking labor forces, and high debt burdens.  Forty-six countries, including Japan, Russia, and China have shrinking populations. 

Negative interest rates are a signal that central banks in major developed countries are taking serious steps to fight slow economic growth.   

 If you think of an interest rate as the fee you pay to borrow money, a lower interest rate means a lower fee. When the fee goes down, banks and people are incentivized to borrow money and therefore, spend more money. Negative interest rates, while unusual, create an even more dramatic incentive to borrow (again, imagine getting paid interest to borrow money) and stimulate more borrowing, more spending, and more economic growth.

Where and when did negative interest rates begin?
Negative interest rates were first deployed by Sweden in July 2009 when the Central Bank cut its overnight deposit rate to -0.25%.  The European Central Bank (ECB) followed in June of 2017 by lowering its deposit rate to -0.10%.  Since then, other European countries and Japan joined in with negative rates resulting in $15 trillion worth of government debt carrying negative yields.

When countries are experiencing deflation (prices going down), from shrinking populations and economic declines, people and businesses may be inclined to hold onto their cash and wait for the economy to improve rather than making purchases or investing in their businesses Also, when prices are falling, there is an incentive to hold onto their cash and wait for prices to go down even further.
By offering a negative interest rate on borrowing, the hope is that borrowing will be incentivized and the money will then be put back into the economy with purchases of goods services and investing.

This strange phenomenon seems unlikely to occur in the United States any time soon.  The U.S. is not experiencing deflation but rather inflation near 2% due to an expanding economy. That should keep U.S. dollars moving and help maintain that momentum, at least for the time being. All that said, there are risks up the road. The shrinking populations and struggling economies of Europe and Asia could be contagious.

While we are used to thinking of paying interest to borrow money, we are living in a time where the lender (the Fed) needs money to be spent to energize the economy and they are willing to pay us to make that happen.  Let’s hope they succeed!