With U.S. short-term interest rates again reaching the zero bound (fed funds rate of 0.00-0.25%), debate has surfaced again about moving the target range further—to below-zero territory. Several developed nations, mostly in Europe, moved down this path years ago, and now remain entrenched in it, with global slowing causing central banks to continue down an easing path. This is despite apparent regrets by some about doing so, due to the lack of effectiveness. (Reversing that stance by bringing rates back above zero would amount to a ‘tightening’ of monetary policy, and counterintuitive to current policy goals, especially in the depths of current Covid-battered conditions.) As recently as last week, the Bank of England reversed a prior stance, and is again reviewing the possibility of negative rates.
It might be helpful to provide a summary on what negative rates actually represent. In normal economic transactions involving debt, borrowers pay interest to lenders for the use of their funds. The ‘lender’ of money can refer to a variety of roles: bank depositor/savings account owner, institution offering a mortgage, or buyer of a bond. The latter relates to the commercial paper of a money market fund, corporate debenture, U.S. treasury bond, and others. In addition to macro factors at the time like inflation, the rate of interest charged includes two components: term risk, which compensates the lender based on the time period of the loan (why long rates are usually higher than short-term rates); and credit risk, to offset the chances of not being paid back. Due to these risks being taken by the lender, a positive rate has historically made economic sense. Otherwise, why lend?
In more extreme cases, a ‘zero’ rate situation can surface. In periods of severe economic distress, for instance, car manufacturers have offered 0% rate loans to some qualifying consumers, since the need to sell vehicles outweighs the benefit of any interest to be earned on loans. Although there’s usually more to it, that’s a trade-off they’re willing to make for potentially higher sales numbers. On the investor side and on a larger scale, zero or near-zero rates (such as for short-term U.S. treasury bills) may be attractive for buyers of bonds with no other options for placement of ‘safe’ assets (e.g. FDIC insurance is limited to $250,000). There, a return of principal is far preferable to risking loss elsewhere. A zero-rate situation was often assumed to be the natural boundary for how low rates could go, to preserve these natural economic incentives.
A negative rate implies the opposite logic. On one side, the lender would shove money at the borrower—in fact, paying them to take it. Many consumers would love a negative rate mortgage, in one popular example, but the risk-return tradeoff for a loan underwriter makes little sense over the long-term. (Note: there was a case of at least one bank in Denmark attempting this, although it had to be assumed money was being made elsewhere, though fees, etc.) The only true negative rates implemented have been by several sovereign governments in Europe and Japan as extreme government monetary policy stimulus. This was seen as easing even ‘beyond zero’, except that the logistical ramifications were quite different. In those nations, the pool of buyers for such bonds is often driven by requirement, such as pension funds, investors in foreign bond index funds, or by investors with such a need for safety or liquidity that paying a premium to own negative-rate securities was worth the trade-off. This market quirk has happened a few times in U.S. treasury bill markets, where the demand for safety has pushed the auction price over the $100 par value; under the assumption you receive only par back at maturity, the yield to maturity morphs into a negative rate. Those are normally self-correcting situations.
Some economic models, such as during the Great Recession and more recently with Covid, have spit out results calling for negative central bank policy rates. This is a natural extension of the 0% level not being ‘accommodating enough’, so the model keeps moving in the easing direction. This explains the policy appeal on the surface by these central banks. However, there are problems over the medium- to long-term with actually implementing negative rates. They have not been shown to be regularly effective in stimulating economies. When looking at this holistically, if buyers won’t purchase goods being financed at a zero interest rate (and/or due to other hang-ups in the lending system, like borrower quality), they haven’t been likely to do so at a negative rate, either. Liquidity in the system has been identified as a greater problem than demand for borrowing during these times, which sub-zero rates won’t help. Moreover, negative rates play havoc on the longer-term operations of certain institutions, specifically banks and insurance companies. Banks operate on the principle of ‘borrow low, lend high’—earning a net interest margin on the spread between rates for loans (assets) and rates paid to depositors (liabilities). This spread will naturally vary with time, but inverting the relationship makes banks unprofitable, and less viable. This isn’t sustainable for very long in an economy reliant on a healthy financial system. Negative rates would also have negative consequences for money market mutual funds, which are a very large part of the financial system, since they’re considered ‘cash-like’ and ‘default-free’ for many investors (despite the disclosures always stating otherwise). These funds had enough problems with viability under a period of post-financial crisis zero rates, when fees were included.
On a consumer level, low interest rates for savers and conservative investors have been difficult enough, but negative rates—implying savers would be charged a fee to preserve the status of safe assets—could be a catalyst for different economic behavior. We’re naturally incented to seek assets that provide payment of some sort, and avoid those that don’t. While part of a central bank’s incentive for negative rates would be to push these savers out on the risk spectrum by buying securities, etc. instead, it could backfire by incenting behavior such as hoarding cash (earning no interest is better than paying fees), or moving to alternative assets such as foreign currencies, or precious metals. Regressive hoarding behavior like this runs counter to the Fed’s goals of increasing economic activity and investment, so would not be a preferred outcome.
There are ways to provide negative-rate like stimulus, though, without an outright negative short-term policy rate. Quantitative easing, which has now been re-accelerated, is the purchase of treasury and agency mortgage bonds by the government. The new artificial demand pushes prices up and yields down, so has the effect of lowering rates below their natural level. Long-term rates are less likely to go down to zero, due to embedded long-term inflation expectations, but such QE allows more targeted policy at key points in the yield curve. The 5- and 10-year areas are especially important, since many consumer, business and home loans are pegged to these durations. Easy monetary policy here may be at least as, if not more, important than merely targeting the fed funds rate.
The Federal Reserve has come out several times over the years (and recently) with the consistent message that it’s opposed to the use of a negative rate policy. Many economists also appear to see such a policy as a low probability event, anomalies aside, but we’ve all learned to never say never.