What’s The Deal With Negative Interest Rates? by John, Vintage Value

Last Thursday, the European Central Bank (ECB) cut its deposit interest rate from -0.3% to -0.4% and ramped up its quantitative easing measures by increasing its monthly bond purchases from €60 billion to €80 billion (including corporate bonds now) in what seems like a last-ditch effort to combat deflation.

What's The Deal With Negative Interest Rates?

This move was highly aggressive – and highly unexpected, but it wasn’t the first negative rate cut to come out of left field in 2016: in January, the Bank of Japan surprised everyone by adopting a negative interest rate policy, cutting its deposit rate from 0% to -0.1%.

Now 2 major economies (the ECB and the Bank of Japan) and 3 other national banks (the Swiss National Bank, the Swedish National Bank, and the Danish National Bank) have adopted negative interest rate policies.

Negative Interest Rates

Today, 30% of all bonds globally (over $7 trillion worth) yield negative rates, up from <10% in 2015 and virtually 0% before 2014. Federal Reserve Chairwoman Janet Yellen even indicated that the United Sates could very well see negative interest rates, if warranted.

It seems clear at this point that negative interest rates are here to stay.

But what even are negative interest rates?

Moreover, how do negative interest rates work? Why do central bankers think negative interest rates are a good idea? And does this mean that banks are going to start charging negative interest rates on deposit accounts and mortgages?

Well, let’s find out.

Lending And Borrowing

Negative interest rates don’t make any intuitive sense.

At some point in your life, you have probably let a family member, spouse, best friend, co-worker, acquaintance, or stranger borrow something of yours – whether it was a pencil, a dress, or a car.

In some instances, you probably expected something in return – e.g. a favor in return or even just a verbal “thank you.” In other instances, you might not have required anything in return – all you expected was to get the item back in the same condition as before.

For example, if you let your neighbor borrow your car for an emergency, you would probably expect the car to be returned in mint condition as well as a thank you note. But if you let your best friend borrow a pencil in class, you might only expect the pencil to be returned (hopefully without chew marks).

This is the same way lending money and borrowing money works. You lend money out and you get interest and principal (i.e. the original amount lent out) back. Sometimes the interest rate is high, sometimes it’s low. Sometimes there is no interest rate at all. But under no circumstance would you ever lend money and expect to have a negative return – that is, never would you lend money and expect to receive less money in the future.

Just liked you’d be unhappy if you lent your neighbor your car and he crashed it, or you lent your best friend a pencil in class and she gave it back to you with chew marks on it, you’d be very unhappy if you lent somebody $100 and only got back $90.

But this is essentially what is happening with negative interest rates.

Negative interest rates are counterintuitive to the natural expectations we have when lending and borrowing.

With negative interest rates, you are literally paying someone to take your money.

Imagine if you went outside right now and offered the first person you saw $100 if he or she borrowed your car for the day. People would think you were crazy.

This is what I mean when I say that negative interest rates don’t make any intuitive sense, and why a negative interest rate policy is considered to be so radical.

But in reality, negative interest rates aren’t all that crazy. And if you have a checking or savings account at a bank or have cash in your wallet, you are essentially being charged a negative interest rate right now.

Before I get to that, let’s first review why central banks change interest rates in the first place.

Why Central Banks Change Interest Rates In The First Place

The Federal Reserve (the central bank of the United States) was established by Congress to (i) maximize employment and (ii) stabilize prices. This translates into a targeted unemployment rate of ~4.7%-5.8% (depending on a number of factors) and a target inflation rate of 2%. The main task of the ECB (the European Union’s central bank) is to maintain price stability (i.e. inflation of just under 2%). Other central banks have similar mandates.

Monetary policy refers to the actions that central banks undertake to influence the amount of money and credit in the economy in order to achieve their mandates. Central banks have 3 main tools that they can use to influence monetary policy:

  1. Open-Market Operations
  2. Setting the Discount Rate
  3. Setting Reserve Requirements

I’ll focus mostly on the discount rate here since we’re talking about interest rates, and I’ll use the U.S. Federal Reserve as a framework for all central banks (even though the Fed hasn’t yet ventured into negative rate territory).

How Commercial Banks and the Federal Reserve Work

Just like families and businesses have accounts at commercial banks (e.g. Bank of America, Wells Fargo), commercial banks also have accounts at the Federal Reserve. This is where the commercial bank holds its reserves – the money it is not allowed to lend out and must keep at the central bank. Think of the reserves as a safety net in case there is a financial crises or distress in the economy; having reserves on hand would help the commercial bank deal with a bank run and would keep it solvent.

In the U.S., large commercial banks must keep 10% of their deposits as reserves in the central bank. This is the minimum amount. Some days, because of the lending and borrowing activities of that particular day, a commercial bank will have less reserves than is required or it will have more reserves than are required (“excess reserves”). If a commercial bank has excess reserves, it can lend that money to another commercial bank that has less reserves than are required via a loan of electronic cash overnight. This is the simplest, shortest loan in the economy and the interest rate for this type of loan is called the “federal funds rate.”

The Federal Reserve can’t choose the rate at which commercial banks lend to each other – the fed funds rate – but it does have the ability to indirectly influence the fed funds rate by setting the “Federal discount rate” and the “deposit rate.”

When a commercial bank needs additional reserves but can’t borrow from another commercial bank because it is uncreditworthy, the Federal Reserve will step in and act as a “lender of last resort.” The interest rate that the Fed charges is called the Federal discount rate (or just the discount rate for short). The discount rate set by the Fed is currently 1%. This sets an upper limit for the fed funds rate, because no commercial bank would borrow from another commercial bank at >1% if it can just borrow from the Federal Reserve at 1%.

The Federal Reserve also pays interest on reserves – both required and excess – that are kept at the Fed. Currently, this “deposit

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