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The implications of negative interest rates

Rates at record lows
As savers in the UK are no doubt aware, the interest they earn on deposits has been at a record low for some time. The “base rate” (the rate at which the Bank of England lends to commercial banks such as Lloyds) has been stuck at 0.5% for seven years.

Rates have been set this low to make it cheaper for commercial banks to borrow money in the hope that they will lend more to businesses and consumers, thus encouraging them to spend more. This is intended to increase the amount of money circulating in the economy and, thereby, boost growth.

You might think that the lowest interest rate a central bank could set would be zero, but recently several central banks, including the European Central Bank (ECB) and the Bank of Japan (BoJ), have introduced negative interest rates.

Implementing negative interest rates can lead to private individuals having to pay for the privilege of leaving their money with a bank. Fortunately, this hasn’t happened yet. Even though negative rates have affected commercial banks depositing funds with their respective central banks, those costs have not yet been passed on to savers depositing money with their local high street bank.

The effectiveness of negative rates is still being debated and investor reaction has been mixed.

Three main concerns

  • First, negative interest rates can make it more difficult for banks to maintain profits. One of the ways commercial banks make money is by charging borrowers a higher rate of interest on loans than the banks pay to customers depositing savings with them. But banks would risk losing customers if they charged savers to place deposits. So if commercial banks are paying to deposit money with the central bank, and paying their customers to deposit money with them, then making money becomes increasingly difficult.
  • Second, negative interest rates can contribute to a “currency war”. Part of the motivation for a central bank to cut interest rates is that it makes its currency weaker (see Chart of the Month) and, therefore, its exports cheaper to overseas customers. But if all countries adopted this approach it could lead to governments imposing trade barriers or other policies to protect their own industries. These measures reduce trade and have a negative effect on global economic growth.
  • Third, negative interest rates might worry investors because it could be a sign that central banks have run out of options and are acting out of desperation. If investors are unsure of the future, they might be inclined to invest less.

However, there are also reasons to take a positive view on negative rates.

Positive view

  • First, negative interest rates have shown signs of working in Switzerland and Sweden, which have lower base rates than the eurozone, but are demonstrating faster rates of economic growth.
  • Second, central banks can take steps to lessen the effect of negative rates on the banking sector. For example, the BoJ’s negative interest rate policy only applies to about 10% of Japan’s commercial banks. Most money placed with the BoJ still earns a zero- or low positive-interest rate.
  • Third, negative interest rates are intended to stimulate the economy by making borrowing cheaper which could stimulate lending growth and boost profits within the banking sector. If this were to happen it could support inflation and enable interest rates to be brought back up to more conventional levels.
  • Fourth, central bankers are not out of options. They could extend policies of quantitative easing which have tended to focus on the purchase of government bonds that are being held by commercial banks. This, in theory, enables these commercial banks to lend the proceeds to businesses and consumers, thus boosting inflation and growth. However, as the ECB recently proved, central banks can expand their purchases to include corporate bonds or equities. More radically, central banks could even give newly printed money directly to households to help stimulate spending.

Central bankers are not out of options
It remains to be seen how successful or otherwise negative interest rates will be in addressing the challenges faced by the global economy. But, for the time being, we believe that zero or negative interest rates are here to stay.

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at May 2016. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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