How Negative Interest Rates Work, and What They Would Mean for the Economy. Negative Interest Rates Explained.
Hello and welcome back to patrick boyle on finance in today’s video we’re going to learn about negative interest rates which have been all over the news recently i’m going to cover the mechanics of how negative interest rates work we’ll discuss where negative interest rates have been implemented and how that has worked out we’ll learn how savers and borrowers are
Impacted and what are the side effects of negative rates if you stay tuned to the end of the video i’ll tell you the six ways university of chicago finance professor john cochran says you can effectively earn an interest rate of zero even if paper currency along with money in the bank is earning a negative interest rate countries all around the world are taking
All sorts of extreme measures to keep their economies afloat during the corona virus pandemic i put up a video a few weeks ago on which country is spending the most in terms of gdp in these efforts i’ll put a link to that above the us federal reserve has already cut the fed funds rate twice in 2020 and there’s debate among some about whether rates should be lowered
Again right now the us fed funds target rate is 0% to a quarter of a percent if the fed lowered rates again to help the us economy rates would drop below zero negative interest rates are controversial but countries such as sweden switzerland denmark and japan have already implemented this approach albert einstein once called compound interest the 8th wonder of the
World adding he who understands it earns it he who doesn’t pays it but at negative interest rates money saved today would instead be worth less every day going forward to better understand negative interest rates it’s helpful to start by looking at the historical background during the global financial crisis of 2007 to 2009 central banks decided to lower interest
Rates as close to zero as possible economies around the world began to recover but at only a slow pace so the central bank’s chose to keep rates low in the hope that individuals and businesses would be encouraged to borrow more increase spending stimulate economic activity and create jobs at zero percent borrowing and spending remained sluggish and nations were
Still worried about deflation so central bank’s introduced an arsenal of unconventional monetary policy measures in order to stimulate real growth and prevent deflation they included central bank purchases of increasingly risky assets forward guidance and negative interest rates so why are people talking about negative interest rates right now will central bank’s
Typically operate under one of two types of mandate a hierarchical mandate which makes price stability the primary objective for monetary policy subordinating all other potential objectives or what we call a dual mandate which recognizes two objectives price stability and full employment and puts them on an equal footing you can look up the inflation target of your
Country’s central bank online but essentially every country has one most developed countries at present have an inflation target of around two percent in emerging markets you see a range of targets from three percent to as high as nine percent inflation is measured by the consumer price index the annual inflation rate for the united states is 0.3 percent for the
12-month ended april 2020 as compared to one and a half percent previously according to the us labor department data which was published in may 20-22 you k cpi has fallen to 0.8 percent so in both cases well shy of the 2 percent well this just means that the cost of living is rising more slowly if inflation remains low for too long employers start factoring it in to
Pay reviews which can dampen consumer confidence and spending economists fear deflation because falling prices leads consumers to defer spending and wait for lower prices in addition they can become unwilling to borrow as the loan will have to be repaid in dollars that are worth more than the dollars that they borrowed companies respond to falling prices by slowing
Down their production which leads to layoffs and salary reductions which then leads to further spending reductions by consumers okay so how do central banks implement negative interest rates negative interest rates impose penalties on those who deposit funds in certain types of accounts for most of the nations that began using negative interest rate policies the
Affected accounts were those held by commercial banks at central banks just like you and i deposit money in banks commercial banks deposit money in central banks this is done for a few reasons one of which is cheque clearing purposes and the other reason is to satisfy central bank reserve requirements by setting negative interest rates on these deposits commercial
Banks are discouraged from keeping excess funds in these accounts and are thus encouraged to lend among the first central banks to pursue negative interest rate policies were denmark’s national bank which started in july 2012 the ecb which started in june 2014 the swiss national bank and the swedish reichsbank which followed in early 2015 for switzerland denmark
And sweden the rationale for lowering rates below zero had more to do with their exchange rates than credit creation the moves were defensive and intended to prevent their currencies from appreciating in response to the ecb’s interest rate policy let’s work through an example in order to understand how negative interest rates work on retail bank deposits if you
Assume that a bank customer deposited a thousand dollars in an ordinary bank account central banks then regulate what a bank can do with that money one of the central bank tools is the reserve requirement which requires banks to hold a certain percentage of their deposits in highly liquid low yield forms such as cash in the bank vault and deposits at the central
Bank only the remainder can be lent out so if for example the reserve requirement was 10% the retail bank would need to hold $100 of the $1,000 deposit either in cash or at the central bank and it could lend the remaining $900 in times of economic uncertainty the bank may choose to hold more than the minimum reducing the amount it lends to less than $900 maybe
In our example we can say to $800 now in order to encourage lending the central bank might impose a negative interest rate on these voluntarily held excess reserves so in our example to extra $100 so the initial $100 that they’re required to hold they’re not being charged this penalty on it’s only the extra that they’re choosing to hold in reserve to avoid this
Penalty the bank would then have to keep excess reserves at a minimum it could lend the excess reserves which is the goal of the central bank so how would negative rates affect savings well savers have already seen their returns to england recent years due to the very low interest rates we’ve been seeing in countries with negative interest rates commercial
Banks have passed them on to big companies who have a lot of cash that they need to store at the bind the evidence suggests though that it’s quite difficult to pass the negative rates on to ordinary savers in sweden they just concluded five years of negative interest rates but banks did not tend to pass these losses onto savers swiss banks only impose negative
Rates on deposits of more than two million swiss francs which is roughly around two million u.s. dollars in germany where some banks impose charges on deposits of more than a hundred thousand euros some people have started keeping their money and saves germany’s largest safe manufacture has seen a wooden third increase in sales since the deposit rate at the ecb
Went below zero so how might negative interest rates affect borrowers well negative rate mortgages already do exist last year a danish bank announced that it would effectively pay borrowers a half a percent a year to take out a 10-year loan it’s worth noting that this was only possible because of the nature of the danish mortgage market where danish banks act as
Middlemen between potential borrowers and investors in denmark the banks don’t take the hit investors do and banks are just charging a pass-through fee so they actually ended up making money out of this negative interest rate mortgage now when uk interest rates were cut to a half a percent in march 2009 some borrowers thought they could be in line for a payment
As they had mortgages that were supposed to track 1 percent below the bank of england base rate their hopes were quickly dashed when financial regulators described interest payments as a one-way obligation on the borrower it’s similarly unlikely that american borrowers would be paid to take out mortgages simply because of the structure of the loan agreements that
Americans enter into with their banks and the nature of the us banking system ok so what are the side effects of negative interest rates there are many side effects associated with negative interest rates for example insurance companies and pension funds struggle in such an environment to meet their commitments due to the ultra low returns on the share of assets
That they’re required to keep in investment grade bonds in addition low interest rates encourage more risk-taking and increased debt which drives up the prices of financial assets such as homes and mercial real estate negative interest rates can hurt bank profitability and end up reducing lending and credit creation finally low or negative interest rates forced
Those would have very low risk tolerance into riskier investments in order to simply maintain their wealth in sweden where they recently ended a five-year experiment with negative interest rates it was argued that when rates turned negative it can contribute to a sense that markets are stepping through the looking glass the strangeness of the financial system makes
People feel so anxious that it undermines the benefit of cheaper loans it’s worth noting that people might behave differently than expected with very low our negative interest rates those who are by their nature inclined to save more than others don’t suddenly rush out borrow money and buy a lamborghini they instead notice that their savings are no longer growing
And they respond by reducing their spending and saving even more in order to meet their financial goals you only need to read the german popular press right now to see how unpopular negative rates are with the public in fact the risk is that negative rates simply fuel fears among investors that something is deeply wrong and permanently wrong so how can you avoid
Being charged negative rates by your financial institution university of chicago finance professor john cochran gave a list of six ways to effectively earn an interest rate of zero even if paper currency along with money in the bank is earning a negative interest rate number one was prepay taxes the irs allows you to pay as much as you want now against future taxes
Number two was buy gift cards from businesses there is even an active secondary market in them online so you could even put a large amount into a gift card and possibly sell it on to someone else number three was by other stored value cards like subway cards postage stamps and so on and he points out that sub cards are anonymous so you can resell them number four
Was prepay your utility bills you could pay in advance a few years off let’s say your gas bill your electric bill your phone bill and so on and number five was prepay your rent or mortgage number six was that businesses can prepay suppliers and leases and they could even possibly prepay wages or at least pre-fund benefits that workers must stay employed in order
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Transcribed from video
What are Negative Interest Rates and How Do They Work? Negative Interest Rates Explained. By Patrick Boyle