Alice laughed. “There’s no use trying,” she said, “one can’t believe impossible things.”
“I daresay you haven’t had much practice,” said the Queen. “When I was your age I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
Alice’s trips to Wonderland and Through the Looking Glass introduce her to one impossible sight after another, from talking flowers and mad hatters, to disappearing cats and homicidal queens. Throughout her journeys, she encounters characters and situations that challenge her sense of reality and grasp of language. Although everything Alice sees defies what she knows to be true, these new realms possess a strange sort of internally consistent logic, abiding by their own rules, if not those of the real world.
Over the past few years investors have stepped through a looking glass of their own, and into a world in which one gets paid to borrow money, and in turn must pay to lend it. A fundamental theory of finance is that money has a time value, and that investors should be rewarded for parting with it. This reward, or yield, should rise with the possibility that they might not get all their money back (credit risk), as well as the length of time they are separated from their funds (duration, or maturity risk).
And yet here we are, in an environment where the combination of money and time does not offer a reward. Money, at least in some parts of the world, has no time value, or even negative time value. Alice would likely agree with the 21st century investor that the current state of affairs only gets “curiouser and curiouser.” In the pages that follow, we explore the theory and practice of negative interest rates, as well as the economic and market implications.
NEGATIVE INTEREST RATES IN THEORY
Monetary theory is based on the principle that central banks can influence investment and spending—and therefore economic activity—by lowering or raising the cost of money. Interest rates are nothing more than rent on money; what you pay to borrow it from others, or what you earn by forgoing current consumption and lending your money to someone else. Lower interest rates make it easier to buy a car, refinance a home, or, in the corporate world, build a new factory and hire people to run it. All this spending and investing boosts Gross Domestic Product (GDP).
Too much of a good thing like economic growth can, however, lead to rising prices and inflation, at which point a central bank can try to stifle overconsumption by raising interest rates to curtail spending and investing before inflation gets out of hand. Interest rates are blunt tools, and central bankers are fallible humans with imperfect information. When central banks inevitably leave interest rates too low for too long, or raise them too quickly, an economic cycle ensues.
The transmission mechanism for central bank policy is the commercial banking sector. The Federal Reserve and the European Central Bank do not dictate interest rates that consumers pay in the United States and Europe. Instead, by lowering or raising the interest rates that commercial banks earn on reserves that they are required to retain for regulatory purposes, a central bank can encourage commercial banks to lend more money (rather than earn paltry returns on reserves), or rein in lending (in favor of healthy returns from reserves held at the central bank).
Inflation is an explicit objective of central bank policy, at least in the United States, but at the same time complicates the effectiveness of monetary policy because what really matters economically is the level of interest rates relative to inflation; that is, real interest rates. Although a central bank sets nominal policy rates, the level of those rates relative to inflation is what really creates the incentive for commercial banks to lend more money into the real economy.
This is an easy and common approach when inflation is at positive and modest levels, but what can central bankers do when inflation falls perilously close to zero, or even turns into deflation? In order to establish negative real rates in a low inflation or deflationary environment, nominal rates must start with a negative sign. It’s just math.
Nominal Versus Real Interest Rates
Assume you are investing money (that is, buying a bond) in a world where real interest rates are modestly positive. If you lend $100 at a 2% (nominal) interest rate when inflation is 1%, a year later you have $102 nominal dollars, but 1% inflation would rob you of one of those dollars. Your ending value adjusted for inflation would be $101. A real interest rate of 1% has increased the purchasing power of your money by $1.
What happens when real interest rates are negative? If you invest the same $100 at the 2% nominal interest rate but with higher inflation of 3%, you still end up with $102 nominal dollars, but only $99 of purchasing power. In this scenario inflation exceeds the nominal rate of interest to your detriment—real interest rates are negative. Your choice is to accept the loss of purchasing power that the bond offers, or pursue other investment opportunities that offer a greater real return. This incentive to allocate capital to higher risk and higher return opportunities is the explicit goal of a negative interest rate policy.
A BRIEF HISTORY OF NEGATIVE INTEREST RATE POLICY
Central banks around the world lowered interest rates to historically low levels in response to the global financial crisis of 2007-2009. At the same time, many central banks bought bond assets on the open market, and expanded their balance sheets to provide liquidity and exert downward pressure on longer-term interest rates, providing even further monetary stimulus and support. As the crisis passed, policymakers expected that economic growth would resume, leading to more inflation, thereby allowing them to raise nominal interest rates back to more normal levels while still maintaining relatively modest real interest rates.
It never happened. Or, at least, it hasn’t happened yet. Major developed economies have grown over the past decade, but not by much. The nearby graph measures the real economic growth of the United States, Japan and Europe, with each economy indexed to 100 at the beginning of the current expansion. The Japanese economy did not return to its pre-crisis real economic level until early 2013, and the euro zone did not regain its previous peak until 2015. The United States, by comparison, recovered all of its lost economic activity by early 2011, and the real economy in the U.S. is now 26% larger than ten years ago in 2009. The euro zone and Japan are only about 14% larger, which equates to a paltry average growth of only 1.3% for the past decade.