LEVERAGE – Negative Interest Rates: The World Turned Upside Down

Imagine a bank that pays negative interest. In this upside down world, borrowers get paid and savers penalized.

At the moment, some 500 million people, in a quarter of the world’s economy, are living with negative deposit rates. Central banks are doing this in an attempt to increase lending, spur along inflation and reinvigorate the economy, after traditional measures have proven ineffective. The fear in Europe is that they will follow Japan into protracted deflation, and so central banks want to avoid this at all costs. Hence the focus on “unconventional” monetary policies that can operate to lift demand when lending rates hit zero.

If European central bank inflation forecasts are met, they should not need negative rates for too long – All expect inflation to increase towards their respective targets by 2017. However, in recent times central bank inflation forecasts have been too optimistic, which means these “temporary measures” could last much longer than expected.

What has this meant for savers?

Bank retail deposit rates are exceptionally low in those countries where central banks have adopted negative policy rates but they have seldom turned negative – zero is generally the floor. Deposit rates have been maintained better for households than for big corporates and for at-call accounts than term deposits.

And the borrowers?

Commercial bank retail lending rates have trended down in the negative interest rate countries but reductions have gradually lost momentum. Banks have been protecting margins, with a less prompt or full flow-through of changes in central bank deposit policy rates into retail lending rates. Where economies are strong or particular market segments buoyant, banks have even lifted margins to help offset the impact of negative central bank policy rates.

Euro-zone housing loan rates are around 2% and have been trending down while new lending to non-financial corporates have also been trending down and varied between 1½ and 3½% depending on loan size and type.

How low could deposit rates go?

The main constraint on making deposit rates very negative is the possibility that banks, business and households might hold their funds as cash rather than in negative rate deposit accounts. The cost and inconvenience of holding cash becomes crucial, a cost that varies according to the type of depositor and sums involved. Will Europeans store their cash in a safe at home?

Many households surveyed by ING in Europe say they would indeed change their behaviour if they faced negative retail deposit rates, shifting their money into other assets or hoarding it. There has been no evidence of such behaviour yet in Europe whilst retail deposit rates remain positive.

It’s still too early to know for sure whether or not negative interest rates are working, and only time will tell if they are able to increase demand and inflation.