LeoGlossary: Negative Interest Rates
Negative Interest Rates are when the borrower is paid interest as opposed to the lender.
Under normal monetary conditions, central banks pay commercial banks on their reserves. When they engage in non-traditional monetary policy, they charge these institutions. This can end up filtering through the entire lending system with most loans ending up paying the borrower.
The idea behind negative interest rate policy (NIRP) is to stimulate lending and get money out into the economy. This is projected to deter savings according to many economists who believe in this viewpoint. Lawrence Summers made a speech in 2013 that was well received in government circles regarding the benefit of NIRP.
Unfortunately, theory and reality can often diverge. When the European Central Bank (ECB) undertook this, it found the economy did not rebound as predicted. In fact, the economic growth rate as measured by GDP was rather stagnant.
Negative Impact
What is overlooked in this scenario is that deposits are not the only asset to lose value. Bonds, especially sovereign debt, takes a major hit. This is a problem because the biggest holders of these securities tend to be hedge funds, insurance companies, and pension funds. We can see how the last one can really affect the fate of a country.
Another issues is the impact upon the currency. When a central bank decides to go negative, the currency ends up sliding relative to others ones in FOREX trading. This is a sign for people to get out of the currency as confidence is waning.
Since 2014, when the ECB went negative, the capital flow out of EURO denominated assets accelerated. The United States was the main beneficiary since the USD has continued to strengthen throughout much of the last 10 years. Flows into USD denominated securities (and real estate) skyrocketed.
Between 2018 and the end of 2022, the Net International Investment Position (NIIP) for the United States showed a net of more than $10 trillion in capital flow.
Eurodollar System
The decision by the ECB, and other central banks, to go negative has affected the Eurodollar market. This depends upon collateral and, traditionally, sovereign debt is the preferred form. Unfortunately, since the Federal Reserve was one of the few who resisted the temptation to go negative, it is now the only form of high quality and pristine collateral.
Going into the Great Financial Crisis, banks and other financial institutions were using not only sovereign debt from many countries but also mortgage backed securities (MBS). Unfortunately, the mis-rating of those securities were heart of the financial implosion. Exiting the crisis, government bonds still were useful for collateralization purposes.
That was until the central banks went negative. It effectively nuked their bond markets, leaving US Treasuries as the only option. This is why that system has experienced deflationary money since the GFC. Balance sheet contractions actually is a major problem as the banks lack the capacity to fund the short-term lending market to the degree that is required. This reportedly accounts for more than 90% of the funding for global trade.
Friedman's Interest Rate Fallacy
Milton Friedman proposed the Interest Rate Fallacy during the 1960s. The main premise is that low interest rates are a sign of not enough money in the economy, not the reverse as many believe.
Since the 1990s, interest rates across the world have steadily declined, to the point they went negative. This is a warning sign to all markets that inflation is not the issue, at least how Friedman defines it. We appear to be in a deflationary cycle which is long term. One of the results is slowly economic productivity as evidence by the global GDP numbers.
This is all happening at a time when technology is rapidly expanding. This is a two-fold issue.
On one hand economic productivity ought to be growing exponentially as technology innovates and make production faster, less expensive, and spread further out. However, technology by definition is deflationary, putting downward pressure on interest rates.
Central banks going negative is obviously not the solution. This was a move that did not have the theorized effect. We are now left with the situation of where is growth going to come from.
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