22 February 2016

What does a negative interest rate really mean?

Andy Haldane, Chief Economist of the Bank of England, has flagged the real possibility of a negative interest rate strat egy.

by John Royden

Head of Research

Negative rates are effectively a tax on deposits, and as such are intrinsically contractionary and therefore a form of financial repression.

I think central bankers have got to devise and implement some sort of solution here.  The starting and simplistic view on negative interest rates is that this discourages bank deposits and encourages people and companies to invest or spend their money; and that gets the economy going again.  At the same time, it encourages banks to lend their money rather than deposit it at a cost, which also helps get the economy going.  And if savers move their money to another currency which actually pays a credit rate of interest, then your currency falls and that helps exports……which generally gets the economy going.

Reduced bank NIM

The starting premise ignores the fact that the clearing mechanism for borrowers and savers is banks.  Bank profitability is substantially driven by their Net Interest Margin, or NIM. In normal circumstances a bank might pay 3% on deposits and lend money at 7%, so earning a 4% NIM. 

You would expect the base rate to be close to 5% in this instance because banks’ rates depend upon what they can deposit and borrow from their Central Bank (lender of the last resort) at. 

If a bank’s Central Bank charges them for deposits (negative 0.5% for example), or lends them money at 0.1%, then that means that banks should really quote their clients something like -2% on deposits and 2% for borrowing;  thus preserving their NIM of 4%.

The trouble is that depositors don’t like being charged for their deposits.  Retail investors can hide their cash under the mattress; and corporates might think about putting £50 ,000 in cash in the company safe. Depositors can in fact buy gilts, which do pay interest, or they can move to Peer to Peer lending platforms or corporate bonds, amongst other options for depositors.

If banks then have to move their rates to 0% for depositors (to stop them leaving) and 2% for borrowers, then their NIM has shrunk to 2% and their revenue halves.  But worse than that, their profits could disappear.  If a bank need an NIM of 4% to make a profit after provisions for bad debts then you could find that an NIM of 2% means the bank is losing money after provisions; so it just stops banking.

So one conclusion you could reach is that negative interest rates might cause lending to shrink, when negative interest rates were designed to do exactly the opposite.

Some have talked about abolishing cash to block the mattress option.  But is that really viable?

Banks are tied to their Central Bank’s base rates

Another consideration is the extent to which the bank is tied to their base rate.  My impression is that UK mortgages are now tied to their bank’s (i.e. Barclays or Lloyds) base rate which is different from the Bank of England base rate.  It looks to me as if UK banks can clear borrowers and savers at a rate which is driven by market forces and not entirely by the base rate. 

The situation in Spain is different, where 98% of mortgages price off Euribor (the European inter-bank offered rate) which is tied to the European Central Bank (ECB “base” rate. So if the ECB’s rates get negative, then not only are Spanish banks bound by an effective floor of 0% on their deposits, but they have to lower their lending rates down and their NIM collapses.  Much of Euroland is like Spain. For this reason, I believe t hat countries with a tradition of tying rates to the Central Bank base rate are more at risk and more likely to just stop lending.

When banks have to deposit a percentage of their loans with their Central Bank under a “Reserve Requirement”, this can make matters worse, as it forces the banks to deposit at negative interest rates and compels them to take a reduced NIM. The US and Euroland have Reserve Requirement banking systems.  The UK does not.

So it actually looks as if negative interest rates could actually dissuade banks from lending and so take money out of the economy; which is the exact opposite effect than that which was desired in the first place.


If you want to get the economy going and don’t like the sound of negative interest rates, then other options are open to you.  “Helicopter money” involves metaphorically throwing newly printed money out of a helicopter, in the hope that people will spend it.  In my opinion, a better way would be to reduce taxes which encourages people to work, rather than hang around waiting for passing helicopters.

The trouble is that the more wily of us realise that less taxes means unbalanced government books, which in turn means more government borrowing, leading to more government debt to be paid back (from the people via higher taxes eventually); this actually encourages us to save to pay off the future debt, rather than spend the cash. This is called the Ricardian Equivalence.

A fiscal stimulus, where the government (electronically) prints money to fund infrastructure projects might avoid the Ricardian Equivalence if the projects yield a return (e.g. tolls on a toll bridge) to return money back to the government over time.

Minimum w age increase

My own view of the problem is that everybody is addressing the symptoms and not the cause.  The cause of our slow growth stems from the fact that back in 2007 the excesses of the system allowed too many companies to build too much capacity into the boom. In the crunch of 2008, the worst of the overcapacity should have gone bust, but it was saved by loose monetary policy lending lots of cash to companies at close to nil interest rates.  These zombie companies (which I’ve written about in Prospects), who should have gone bust, don’t earn a return on their capital and are kept alive by low interest rates. But they do clog up markets and consume capital and labour which would really be better deployed elsewhere; and zombies block entrepreneurial activity as well.

Zombies explain the productivity conundrum because you don’t invest money in a company with a nil return on your investment. You hire extra workers to cope with more demand. These workers won’t ask for a pay rise because they know they will bankrupt the company and they will lose their jobs; hence low wage inflation, relative to our low unemployment.

Even if you are a good company, you might meet increased demand with more employment and avoid capex investment if the future looks uncertain.  And if rates are low, which in turn reduces the required return on investment, you might just think that capex is just not worth the bother.

Chancellor Osborne’s minimum wage inflation might be a gentle way of putting pressure on companies to invest in productivity improvements and a gentle way of forcing the zombies out of business without the alternative of hiking rates, which would bankrupt a lot of mortgage borrowers and businesses. As a house owner, I am well on George Osborne’s side.  As a young twenty-something despairing at high house prices, I might w ell be inclined to vote for a rate hike and a property crash.

To summarise, as long as banks choose to absorb that tax that is negative interest rates themselves, those who pay that tax will effectively be bank shareholders and employees.  But if banks choose to pass that tax on, it will be savers and borrowers who end up paying it. I cannot see necessarily that the increased economic activity that negative interest rates may generate, will be sufficient to offset the effect of this tax.

Alternatively, if we think of negative rates as a monetary operation rather than a tax, we can say that the central bank drains back a small proportion of the reserves it adds to the system through QE.  This is effectively monetary tightening. Again, I question whether the increased economic activity generated by negative rates would be sufficient to offset this effect?

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