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In the Nation's Interest

Negative Nominal Interest Rates: Uncharted Waters

By Jeffrey Hooke
Vice President and Director of Economic Studies

ECB Looking at Negative Nominal Rates

Mario Draghi of the European Central Bank (ECB) suggested that the ECB may consider implementing a negative nominal interest rate policy for short-term deposits.  This possibility is news.  Negative nominal rates are unusual, and central banks haven’t attempted to support negative nominal interest rates on a large scale.

With a negative nominal interest rate, the depositor essentially pays a bank to hold the depositor’s money.  If the annual negative nominal interest rate is minus 1 percent (-1%), for example, the depositor places $100 with the bank on January 1.  A year later, the bank returns just $99.  In all likelihood, any investor who accepts such terms – and who has any alternatives – is paying for security.

Difference Between ‘Negative Nominal’ and ‘Negative Real’ Interest Rate

Don’t confuse a negative real interest rate with a negative nominal interest rate.  A negative real interest rate means the deposit (or government bond) has a positive coupon, but, after inflation is factored in, the true investor return is below zero.  To illustrate, the 12-month yield on U.S. Treasury securities is 0.1% (10 basis points).  If you believe most experts, who say inflation for the next year will be around 2.0%, then the real return on the investment is minus 1.9%, so the investor loses purchasing power in U.S. dollars by buying the security.

Real Return Calculation – 12 Month U.S. Treasury Security

U.S. Treasury Yield             0.1%
Less Expected Inflation     2.0%
Real Return                          -1.9%

ECB Concerns
The ECB’s contemplation of the negative nominal rate reflects two concerns:

  1. Current Low Interest Rates in Euros Not Stimulating European Union Economy: The ECB’s existing interest rate policy (rates are close to zero for short-term instruments) has failed to push businesses and individuals (i) to borrow money; and then (ii) to invest/spend the proceeds.  By putting nominal rates into negative territory, the ECB would hope to make borrowing more attractive, and thus to promote economic activity.  Negative interest rates also encourage cash-rich investors to put more money into longer-lived corporate assets such as stocks and bonds, which generally have higher risk-adjusted returns than short-term deposits and government securities.  Such assets are associated with more-productive uses are than short-term deposits.
  2. Deflation Potential: Inflation in the European Union is running at an annualized rate of about 0.5%, far lower than the ECB target of 2%.  The persistent low inflation rate, due in part to the slow economic recovery, has sparked talk of deflation.  Deflation occurs when the prices of goods and services decline.  Modest deflation can depress economic activity, by encouraging consumers (and businesses) to wait for prices to fall further and thus to delay their purchases. The resultant downward price pressure makes debts (which are denominated in fixed amounts) more difficult for consumers and businesses to repay, thus potentially fuelling a financial crisis.  Businesspeople tend to associate deflation with recessions, so deflation is looked at as an enemy of developed economies.

Past History and Negative Nominal Rates

In the past, the occurrence of negative nominal interest rates reflected both ‘safe haven’ and recessionary conditions.  Set forth are some examples.

  • 1970s Switzerland:  To avoid the investment losses caused by devaluation in their home currencies, foreign investors desired the Swiss franc’s stability.  To discourage this flight to quality, and too large an increase in the franc’s value, the central bank instituted nominal negative interest rates on foreign deposits from time to time.
  • 1990s Japan:  The stock market collapse and poor economy prompted local investors to buy safe government bonds, dropping yields to negative levels at times.
  • 2009 Sweden:  During the financial crisis, Sweden had a brief spell of negative nominal rates on short-term deposits.
  • 2012 Europe:  Belgium, France, Germany and Netherlands sold short-term government bonds at small negative nominal rates.  Denmark and Switzerland cut deposit rates below zero, as investors sought refuge from the Euro currency.

At the depths of the financial crisis, in December of 2008, some short-term U.S. Treasury securities traded at negative nominal interest rates for short periods of time.  However, these were market rates set by very nervous investors, not policy rates set by national monetary authorities.  Also, the U.S. Treasury Inflation Protected Security (TIPS) has been issued at a negative yield from time to time.  However, the TIPS is different from a normal Treasury bond, because the TIPS return is adjusted for inflation on a lagged basis.

Closing Issues

From a back-office standpoint, processing transactions with negative nominal interest rates, such as repos, CDs and other short-term trades, should be achievable, because the related software should work with negative numbers.

Observers have cautioned on possible side effects, which may defeat the purposes of boosting European Union economic activity and lessening deflation prospects:

  • Consumers, or businesses, could pull deposits out of banks in favor of cash (cash will not have a negative yield).  The impracticality of holding large amounts of cash seems to limit this option. Someone might invent a cash-currency-only exchange-traded fund (ETF) to surmount this problem.  (However, the inventor will expect a return for his or her innovation.)
  • The free enterprise system might create other means for individuals and businesses to avoid the implicit penalty on deposits, particularly if the negative rate becomes large enough (in absolute value) for interesting and possibly disruptive tactics might pay off.  Paying expenses in advance to limit cash deposits is one example.
  • A bank might have an incentive to hoard the cash that depositors pay them to hold, instead of on-lending to fresh borrowers.  Quality borrowers are hard to find in the current environment.
  • Some banks (and others) may be tempted to boost participation in the carry trade, buying longer-dated, safe government bonds in Euro or other currencies, instead of on-lending to corporations and consumers.

Negative nominal interest rates in the European Union might cause a rise in demand for dollar instruments, thus propelling already low U.S nominal rates to negative levels.  The U.S. Federal Reserve, along with the U.S. financial markets, would then be in some interesting uncharted waters.