September 29, 2020
Negative Interest Rates – What are they?

Recently the Bank of England – like the central banks in a growing list of countries – has hinted that it could use negative real interest rates in a bid to boost the economy. We at Pynk thought we would take this opportunity to discuss what this means for you in practice.

Negative interest rates, that is getting paid to take a loan or a mortgage, sounds nice in theory, but it isn’t. The effects of negative interest rates are complex, and they impact a wide range of areas beyond just borrowers. Savers, banks, companies, and governments are also affected by the repercussions. In fact, it’s a central bank policy that has already been tried and tested in Japan and across Europe with limited success: governments have resorted to implementing negative interest rate policy in response to weak underlying economic conditions (exacerbated by aging populations) but these policies have shown mixed results to date in terms of boosting growth and are starting to have unwanted and unintended consequences in day to day life.

The theory behind the use of negative interest rates

By setting interest rates below inflation, the Central Bank is seeking to impact the rates at which banks are lending money to individuals and businesses. Using negative interest rates, the Central Bank is trying to stimulate the economy by injecting more liquidity into the system through lending. When interest rates are negative, it means that a commercial bank would pay to store its money with the Central Bank. It is therefore a strong incentive for the banks to lend the money rather than keeping it.

‍A Negative Interest Rate Policy (NIRP) from a Central Bank is an extreme measure. The reason markets get worried when NIRP becomes policy is that it means the central bank sees a very high risk of Deflation (price falling) in the economy. Counterintuitively, prices falling is not a good thing, even for consumers.

Deflation could be a vicious circle because consumers keep postponing spending, expecting prices to fall even further. If deals will be better tomorrow, you keep waiting for the next deal. Prices start to fall because there follows overcapacity in the economy compared to economic demand. This leads to unemployment or salaries decreasing, further depressing economic growth.

The Real World Experience

In theory, negative interest rates are potentially a good tool to fight deflation by stimulating lending. But this is in stark contrast to the experiences of many European Countries and that of Japan for several years. Japan and Europe are facing similar demographic challenges with their population getting older and economies experiencing slow economic growth. Despite the Bank of Japan (BOJ) adopting negative rates in 2016 1, Japan has continued to struggle against deflation (actually since the 1990s). In Europe, we have an explosion of negative interest rate policies being implemented to put pressure on commercial banks but again, it’s difficult to argue that the policy has been an unmitigated success.

The Unintended Real-World Impact of Negative Interest Rates

For many years, the impact of negative rates on the commercial banks wasn’t visible, but this is starting to change. Taking Denmark as an example, in August 2019 1, the Danish bank Jyske Bank, became the first to pay borrowers to get a mortgage! It introduced a 10-year fixed-rate mortgage at negative -0.5%. In practice, you still had monthly repayments, but you ended up paying less than you borrowed in total. Getting a mortgage in Denmark then became extremely cheap. Nordea Bank offered a 20-year fixed-rate mortgage at 0% and a 30-year fixed mortgages at 0.5% interest rate!

With such low rates, banks then had to resort to trying to make money by charging a high fee or selling additional services like mortgage insurances for example. So, it became in practice less advantageous to consumers than it seemed. Like everywhere else in the world, credit also became only available to a smaller subset of consumers, which blunted the economic force of providing credit more widely. Overall, getting paid to take a mortgage is nice but in this real world example of Denmark, it meant you needed to borrow much more because everyone was accessing cheap mortgages with the consequence that houses prices rocketed to all-time highs. With these extremely cheap mortgages, house prices became expensive and household debt exploded to its highest level ever.

Savers also hit

In the same way that negative rates may encourage you to borrow and spend money, they are also a strong incentive not to save money. In countries with negative interest rates, we are starting to see a trend of banks passing these negative rates to savers by charging a deposit fee. So, the same bank that is offering you a negative mortgage could be charging you a negative interest rate on your deposits and the pressure is mounting even on small savers. This may eventually have the unintended consequence of not only impacting consumption, but the danger could be that instead of spending, savers start to take more risks: either by physically keeping more cash at home or by investing in financial products which are riskier as they don’t have other attractive options for their money.

Good News Overall for refinancing your debts

On a positive note, negative interest rates are an excellent opportunity to refinance and to consolidate your debt at cheaper rates. The problem as we have already seen happening around the world: negative interest rates cut the profitability of banks and this makes them extremely selective. The risk borne out by recent experience is that only excellent creditworthy borrowers can access money at very low or negative rates and borrowers with a more average or bad credit score are excluded. This trend would obviously be accentuated by the fact that savers may stop placing as much of their money in savings accounts with the net result that banks may have less money to lend.

What about the Markets?

Most investment experts agree that equity and bond markets are at extremely stretched valuations relative to the past, and that a market correction may be imminent. But what if the lack of attractive alternatives due to negative interest rates actually persuades people to stay invested? The consensus amongst experts isn’t always right and it may be that money continues to pour into markets for a lot longer than people imagine it could. Time will tell and there is good reason to be cautious after such a long bull run: over long periods of analysis, it’s clear that high market valuations invariably mean lower rewards over subsequent periods. Nevertheless, negative interest rates may have the unintended consequence of prolonging current conditions in the markets.

Written by
Pouneh Bligaard
View all my posts →
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