What are negative interest rates and could they happen here?

Negative interest rates – where banks pay you to borrow money – now exist in many parts of the world. John Stepek explains why they are a terrible idea, and how likely we are to see them in the UK.

Bank of England chief economist Andy Haldane ©
BoE chief economist Andy Haldane: negative rates not the first port of call

Among the many weird and not-so-wonderful monetary policy innovations that the 2008 financial crisis helped usher into the public realm, fewer are stranger than the idea of negative interest rates.

Interest rates have already gone negative in Japan and in many parts of Europe. But now, as the coronavirus crisis rumbles on, investors are starting to bet on the possibility of negative interest rates in the UK and the US (not least because Donald Trump has been calling for them over in the US).

Advertisement - Article continues below

So how do they work, and what would it mean for investors?

Imagine getting paid to borrow money

In many parts of the market, lenders are already being charged to lend money to governments, as we’ve seen with negative bond yields. However, when we talk about negative interest rates in this context, we’re talking about the central bank deliberately setting its key rate (eg, the bank rate in the UK, or the federal funds rate in the US) below zero.

Japan, the eurozone, Switzerland and Denmark already have negative rates. Sweden had them for five years, but ended the policy at the end of last year. In both the US and the UK, rates are still positive (albeit barely).

So what is a negative interest rate? It’s exactly what it suggests: you get paid to borrow money and you get charged to lend money. So if you took out a 25-year mortgage with a negative interest rate, then at the end of the 25 years, you’d repay less than you’d originally borrowed.

Advertisement - Article continues below
Advertisement - Article continues below

Why do central banks turn rates negative? Well, the point of negative interest rates is exactly the same as the point of ultra-low interest rates: they are designed to persuade those with capital to take more risk with their money in the hope of earning a return, and also to persuade borrowers to take on even more debt and thus boost economic activity.

In other words, you’re essentially forcing people to speculate, because otherwise their money will be eroded over time.

There’s one obvious problem with negative rates. If I start to charge you a significant amount for holding your money in a bank account, then you could always just pull it all out and stick it in cash under the mattress.

Yet, as ever, economists have a solution for this. Economist Kenneth Rogoff – who with Carmen Reinhart worked on a very influential paper on sovereign debt (Growth in a Time of Debt), which turned out to have a mistaken formula in the spreadsheet – has been an advocate for negative interest rates for a long time. A couple of weeks ago, he had an article on the Project Syndicate website arguing for them again (worth noting in passing, is that Reinhart doesn’t agree with him on this).

Advertisement - Article continues below

In it, he argues that governments could take the hit for shielding everyday depositors from negative rates. And at the larger scale, to prevent institutions from sticking banknotes in safes, you introduce lots of new regulations. Also, “phasing out large-denomination banknotes should do the trick”.

Why negative interest rates are a terrible idea

The funny thing about Rogoff’s column is that he somehow seems to think that this incredibly authoritarian step – in effect, banning cash from the financial system, except for (in global terms) petty cash purposes – is less disruptive than quantitative easing or debt restructuring.

Advertisement - Article continues below

There are so many problems with negative interest rates that it’s hard to know where to start. It’s terrible for the banking sector, for a start, and given that it’s hard to have a healthy economy without a healthy banking sector (banks are still the main mechanism by which central bank policy is transmitted to the rest of us, after all), that’s not a great idea.

Advertisement - Article continues below

But there’s a much bigger risk here too – and that’s trust. Money is a social technology. It’s a set of rules that we all broadly agree on. It’s easy to forget that there is nothing inevitable about these systems, but the fact that every paper currency in history has eventually foundered – along with the systems they were part of – is clear evidence that this stuff only works by consent.

This is why it’s so disorienting for people when everything goes wrong and they get a glimpse of the financial plumbing. That’s why 2008 came as such a shock. It was a psychological blow that we still haven’t recovered from.

If you introduce negative interest rates, that’s yet another psychological blow. How can it make sense to lend money and expect to get less back? To economists, there may be no difference mathematically between a “real” return (a return after inflation) and a nominal return, but to normal people, there’s a huge difference. And understandably so.

Advertisement - Article continues below

A “real” return incorporates an estimate of an abstract concept – the rate of inflation. A nominal return requires no such guesswork. If you make the monetary system too complicated for most people to put aside the time to understand it, then you won’t get added activity – you’ll get paralysis, at best.

Advertisement - Article continues below

This is before we even get into the idea of whether it’s a good idea to be forcing anyone to speculate at a time when we’ve already been driven to valuation extremes by existing central bank policies.

In short, it’s a stupid idea.

The good news is that, despite the various headlines that have come out of The Sunday Telegraph's weekend interview with Bank of England chief economist Andy Haldane, it doesn’t read to me as though negative rates are seen as the first port of call.

It’s clear that the Bank would be more interested in buying other assets – corporate bonds, perhaps even equities (Haldane doesn’t say that, but he does talk about “assets further down the risk spectrum.” I suspect the Federal Reserve feels the same way.

Advertisement - Article continues below

However, the fact that negative rates are coming up again is just yet more evidence to me that policymakers are past the point of caring. They will do whatever they feel is within their power to ignite inflation and keep the show on the road.

That might help to explain why not just gold, but also silver, is finally on a tear. Perhaps the rebound will be stronger than we think. Perhaps you should make sure you hold some (gold that is – silver is fine for a punt sometimes, but terribly mercurial as my colleague Dominic has often lamented).

And if you don’t already subscribe to MoneyWeek magazine, make sure you do. A move into an inflationary environment would be one of the biggest paradigm shifts in the entire investing lifetimes of anyone under the age of 60 (at least). You can get your first six issues free here.




How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019

Money Minute Wednesday 4 December: Britain's economic sentiment and American job figures

Today's Money Minute looks ahead to the UK's latest all-sector PMI survey, and America's private payrolls report.
4 Dec 2019

Beyond the Brexit talk, the British economy isn’t doing too badly

The political Brexit pantomime aside, Britain is in pretty good shape. With near-record employment, strong wage growth and modest inflation, there is …
17 Oct 2019
UK Economy

Mervyn King: why the Covid pandemic is a classic example of radical uncertainty

This week, Merryn talks to ex-governor of the Bank of England Merryn King about the pandemic and how to prepare for a future that is unknowable; the g…
2 Jun 2020

Most Popular

UK Economy

What bounce back loans can tell us about how we’ll pay for all this

The government will guarantee emergency "bounce back loans" for small businesses hit by Covid-19. Inevitably, many businesses will default. And there'…
1 Jun 2020

This looks like the biggest opportunity in today’s markets

With low interest rates and constant money-printing, most assets have become expensive. But one major asset class hasn’t. John Stepek explains why com…
2 Jun 2020

These seven charts show exactly why you must own gold today

Covid-19 is accelerating many trends that were already in existence. The rising gold price is one such trend. These seven charts, says Dominic Frisby,…
3 Jun 2020