Negative Interest Rates – August 2019
Negative what? One of the things I love about writing a newsletter is that I get to research answers to my own questions.
Sometimes. Digging into negative interest rates turned out to be more time consuming than I thought.
Talking to friends in the industry it was clear to me there is more than one definition for what a negative interest rate policy (NIPR) is and what it does.
For the purposes of your investing, having a handle on a NIRP is a tool you can use before you despair over the very low interest rate environment we are in.
Here are three descriptions of NIRP:
- If you have a checking account or savings account that you do not use but are charged a monthly fee, the fee will eat into your savings and cash. When you withdraw your cash, you will have less than you deposited. This is called a negative interest rate.
- The government of a country issues a bond with a negative interest rate. In bond language bonds are sold at par (100), a discount (99) or a premium (101). The government sells you a bond at a premium (101) and when the bond matures you receive par (100). This is a negative interest rate.
- A central bank, like the Fed, has the power to increase or decrease short term interest rates. Decreasing rates is a monetary policy tool that central banks use to stimulate an economy. By creating an effective negative interest rate policy the idea is to push cash and savings away from a mattress and into a higher yielding investment.
The conventional definition of negative real rates involves inflation:
Nominal interest rates minus the inflation rate equals a real rate of return.
In English this means if the ten-year Treasury bond is yielding 1.50% and the inflation rate is 2.00% then the real rate of return is negative 0.50%. Prices on goods are going up at a rate that is higher than the yield you earn from a treasury bond, so your real rate of return is negative.
The central banks of Sweden, Denmark and Switzerland have all implemented negative interest rates.
The purpose of a negative interest rate policy is to prevent an economy from slipping into a deflationary spiral followed by a recession.
In the case of Switzerland it was a policy tool used to deflate the value of the currency.
What is problematic about a negative interest rate is that it is based on a theory about what savers will do.
If you have four flat tires on your car and you try to inflate your tires with a bicycle pump, in theory you will eventually have fully inflated tires and drive away.
You and I both know that using a bicycle pump for the tires on your car is not a guarantee that you will be able to inflate the economy. I mean tires.
In an economy, when the air starts to seep out of the tires, we know it means household spending is slowing, business investment is slowing, prices start to go down, deflation is on the horizon. You can hear the hiss of air escaping the tires.
As as it sounds, negative interest rates are used like the air pump at the gas station.
You are paying for air to quickly inflate your tires and get your car moving again. Negative rates should start to pump up the economy.
One possible scenario for a NIRP is the bank charging you a fee to “store” your cash. You deposit a dollar and they give you back 95 cents.
Why would anyone deposit cash knowing they will get less back. Exactly!
Instead of depositing cash in the bank for safe keeping you start to think about investing in something that will give you a positive return. Or you think about borrowing money at a low rate to fix up your home.
A 2.00% dividend yield on a stock or 1.00% on a bond is looking pretty good compared to the less than zero percent on your savings account.
Of course, this is exactly what the central bank wants you to do. Spend your money (positive for growth) or invest your money (positive for growth). Both spending and investing begin to inflate the tires that keep an economy rolling.
The problem with a negative interest rate policy, we are going to call it a NIRP, the problem with a NIRP is that NIRP’s are ambiguous. A NIRP should do this, it may do that, it might do nothing. No one knows for sure what the little NIRP is going to do.
There isn’t any evidence to show that a central bank that pursues a negative interest rate policy has succeeded in stimulating growth in an economy.
Just discussing the possibility of a NIRP entering the economic system is enough to cause the very reaction central banks are trying to achieve. I think it’s called “a self-fulfilling prophecy”.
Theoretically, a NIRP will cause asset prices to increase, thus creating a “wealth effect”. As interest rates go down, bond prices are going up, mortgage rates are going down and individuals are more willing to borrow and spend.
I think it unlikely that banks will adopt negative rates on individual deposits so I wouldn’t try to move cash to a storage locker in New Jersey. Anyway, you pay a fee for the storage locker.
If you have been thinking about buying a dividend paying stock or a very short-term bond for a small percentage of your assets now might be the time.
And next time you are out with friends or in a heated debate on economics you can jump right in and say – I know exactly what a NIRP is!
Other Articles used for this Newsletter:
https://www.investopedia.com/terms/n/negative-interest-rate-policy-nirp.asp
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
