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What are the consequences of negative interest rates?

What are the consequences of negative interest rates? Shaun Richards

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This week has seen for the first time a major central bank dipping its toe into the world of negative interest rates. Instead of receiving interest on deposits, there will be a requirement to pay interest on them, which is quite a sea change. For now, the European Central Bank has only dipped its smallest toe in this particular pool. The subsequent interest rate will only be to the order of -0.1% on its deposit account, which is part of the way it acts as a central bank for euro area banks.

This represents quite a change

Before the credit crunch era began, the concept of negative interest rates was pretty much ignored by markets. For example, most interest rate futures had a ceiling at 100 which represented zero interest rates. As you can imagine, there has been a bit of rewriting of contract specifications since! Also, central banks were initially both afraid and concerned about the effects of negative interest rates. A bit like the Y2K bug, there were concerns - particularly at the Bank of England - that banking IT systems were antiquated and might not be able to cope with negative interest rates. This led to concerns when the Bank of England cut its base rate to 0.5% as the Cheltenham and Gloucester Building Society had a tracker mortgage which was 0.54% below the base rate so effectively it became -0.04%. The product itself was quickly withdrawn, but there were existing mortgage holders who were paid - albeit only a small amount - to have a mortgage. I have always believed that this reality was a factor in the way that the Bank of England did not cut base rates below 0.5%, as it was afraid of the potential consequences.

Has anybody tried it?

The most recent venture into this area came from the central bank of Denmark (Danmark's Nationalbank) in the summer of 2012. Rather ironically, it came because its currency is pegged to the euro! Although of course there is a clear link, as the need to cut interest rates in the euro area comes from the fact that many euro area countries cannot cope with the fact that they have a fixed currency with many of their trading partners. Even worse, when they trade outside of their currency bloc, they face a euro exchange rate which has been appreciating since July 2012. The fact that the dates quoted here are similar is not a coincidence.


What were the effects?

I am sure that many of you are wondering whether negative money-market rates got passed onto depositors, so let the Chief Economist of Danmark's Nationalbank reply:

"Banks have not in general introduced negative retail rates."

So, as depositors let out a sigh of relief that they will not automatically face interest rate charges on their savings, we are still a little unsure as to at what point such a move would become widespread. Some economists are already preparing themselves for such a possibility by suggesting the end of paper money because, whilst it offers no interest, that is still better than a negative one. Accordingly, they fear a type of "dash for cash". Also, those who face other types of charges on their bank accounts may feel they effectively have a negative interest rate already.

But financial markets did respond, so we can feel that a further nudge lower would have seen negative interest rates for depositors:

Pass-through to the money-market and exchange rate have been clear.

Also, the fear that crossing zero interest rates would be a form of crossing a rubicon diminished:

Based on banks’ interest-rate margins it seems as if the banks react to low and decreasing interest rates, not specifically to negative rates.

What has the ECB learnt from this?

At the most basic level, it realized that the financial world in Denmark did not come to an end when some official interest rates dipped below zero. It is also not necessarily the case that all deposit interest rates will go below zero although some may. However, the catch here is that we are defining a weak transmission mechanism which means that the expected benefits such as lower borrowing interest rates for businesses will be patchy too. In short, it is less of a big deal than thought in the past in reality - although of course the symbolism is large and there is the possibility of further cuts.

The main hope of an effect will be via the exchange rate of the euro where negative interest rates may have an impact. Although even here we face the fact that two interest rate reductions in 2013 helped little in this regard.

The Danes, however, will be permitted a wry smile as they recently ended their adventure into this arena, and will presumably find themselves back in it in short order. Oh what a tangled web and all that!


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Tags: ECB , European Central Bank , Mario Draghi , negative interest-rates
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