Living & Investing in a World of Negative Interest Rates

At many of the world’s central banks, setting key interest rates is the primary tool for conducting monetary policy. Their goal? Stabilize economic activity. When central bankers are worried about inflation, they can raise rates. This increases the cost of borrowing, giving more reason to save.

In the midst of an economic recession, central banks can slash interest rates. This cuts the cost of borrowing money, encouraging business investing and households to spend more.

So What’s the Deal with Negative Rates?

When interest rates approach what economists refer to as the “zero lower bound”, central banks cannot stimulate the economy. Cutting rates, once an effective tool, has broken through conventional theories. This has brought broader monetary policy issues into question.

Therefore, when a central bank introduces negative interest rates, they pursue unconventional monetary policy.

Despite cautionary rhetoric from many respected economists, central bankers around the world have chosen to embrace negative interest rates. With about 25% of world GDP coming from countries with negative interest rates, it seems they are here to stay.

Switzerland and Denmark both pursued sub-zero rates. They did so in an effort to curb currency appreciation. They also hoped to slow hot money from entering their economies. International investing has subsided since. Japan’s rates have been hovering around the zero lower bound for well over a decade. In 2016 they went negative. Domestic investing is also scarce in the country.

The Bank of Japan instituted negative rates to drive up demand and bring the economy out of years of stagnation. The European Central Bank has also pursued similar interest rate policies with uncertain success.

So What Does that Mean For Investing?

Interest rates determine the cost of borrowing capital for investing (or any other reason) or the interest received on deposits. Like people receive interest on deposits held at their bank, commercial banks hold large reserves at their central banks. And guess what? They also receive interest. In the case of negative interest rates, banks no longer receive interest on their reserves. But they instead pay a fee to the central bank for holding their money.

This practice runs counter to the intuition behind traditional banking practices.

If you to pay a fee to store money, you’d be better off holding onto that cash. This is because cash can’t incur a negative interest rate. Hence, some worry that cash hoarding and shrinking deposits may discourage banks from lending.

Negative rates also put significant pressure on bank profits, which may contribute to large sell-offs or indirectly restrict economic growth. Alternative Bank Schweiz boss Martin Rohner noted the Swiss National Bank’s introduction of negative rates had cost the lender “pretty much the equivalent of [their] entire annual profit” for 2014.

Are Negative Rates Effective?

A Bloomberg survey of economists rated the negative interest rate policies of Switzerland and Denmark as effective. The ECB also deemed that Japan’s efforts were ineffective.

Negative rates are more effective for controlling currency appreciation than stimulating demand and growth.

In theory, a charge on deposits in central bank reserves would incentivize member banks to avoid that loss. They would invest their money elsewhere in the form of loans or other assets. This, in turn, would boost the economy. On a macroeconomic level, it would discourage savings while encouraging investment and consumption, leading to increased aggregate demand.

For now, negative interest rates seem to be a feasible tool for controlling currency appreciation. They’re also effective at curbing deflationary trends and incentivizing investment. However, they are a relatively new instrument of monetary policy. That means we unfortunately do not have data or evidence of its potential long-term impacts on any economy.

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Originally published at https://blog.rapunzlinvestments.com on November 16, 2017.