Bloomberg recently reported that some European corporate bonds are now offering a negative yield due to interest rate distortions by the European Central Bank (ECB). But what does it mean to have negative interest rates and how does the ECB or other central banks make this possible?

First, let’s start with an example of your own bank account. You deposit money in your bank savings account, the bank will then lend out your savings to borrowers they view as creditworthy. The bank pays you an interest rate to compensate you for using your money. But the bank also has its own bank where it can deposit money: a central bank (in the United States this is the “Federal Reserve”). Normally, a bank will not lend out all of its deposits but will keep some “reserves” to meet the withdrawal demands of its customers as well as cushion it against any losses. A bank will keep these reserves deposited with the central bank and historically the Federal Reserve has not paid any interest on those reserves.

But a number of years ago the Federal Reserve and other central banks added a “tool” to their monetary toolbox – the ability to pay interest on those reserves. The Federal Reserve has currently kept this interest rate very low, 0.25%, so banks have an incentive to lend money out at higher rates and make more profits. But the ECB has instituted a small negative interest rate, -0.20%, which is equivalent to charging banks to keep their reserves deposited with them! To go back to your own savings account as an example, if interest rates were negative 1 percent and you had $100 in savings, then after one year you would only have $99! Note that we are not talking about inflation or what your money is effectively worth; we are expressing everything in nominal terms, so an actual dollar gets deducted from your account.

Why would a central bank do this? We must go inside the mind of a central banker and look at their job and underlying theory to try to understand. We often hear that it is the central bank’s job to “stimulate” the economy or keep it growing, and above all, not to let it slide into a recession! Central banks around the world are now committed to this idea and one of their main tools to try to spur the economy is lowering interest rates. (As a technical aside, central banks only control a few key interest rates, but other markets and interest rates, such as corporate bonds, are based off of the key rates central banks set and therefore tend to move together.)The theory is that by lowering interest rates, people will borrow more to either buy things or expand their businesses which in turn “jump starts” the economy. The problem is that central banks have kept interest rates near zero and their economies still seem sluggish. Therefore, the next logical step to them is to push interest rates down further into negative territory! The central banks believe that by punishing banks for holding reserves they will incentivize them to lend.

As you can see, negative interest rates are merely an extension of central banks’ mindset: to jumpstart the economy, lower interest rates; if that doesn’t work, repeat, even lowering them further into negative territory. In other words, when you are hammer, everything looks like a nail. Unfortunately this strategy leaves no room for the possibility that the central banks’ underlying theory may be wrong. Banks already have a large spread between what they pay depositors and what they charge for loans, but despite this they have not made large amounts of loans and instead have let their reserves pile up at the central banks. This suggests the problem is structural. Bankers see too many risks on the horizon or can’t find enough worthy borrowers or investment opportunities. If the problems affecting global economies are structural and can’t be solved by simply lowering interest rates or printing money, then no amount of interest lowering will help and will only make matters worse.

Also important to realize, is that negative or even zero interest rates are only possible because we have central banks that are directly manipulating them. To have zero or negative rates implies that the time value of money does not exist! Interest rates are like prices, and prices reveal information and coordinate activity. Tampering with the price mechanism, in this case consistently suppressing interest rates, will only lead to distortions…and disaster.

Chris Kuiper, CFA is currently a student and researcher at George Mason University pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.

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