Yesterday, the ECB* governor Mario Draghi emerged from a meeting and announced that the ECB would be:

  • dropping the ECB refinancing rate (the refi) down to 0.5%; and
  • keeping the deposit rate at zero percent; although
  • the ECB stands ready to drop that baby into negative territory if it needs to.

 
It’s not often that you hear talk of negative interest rates. I mean, yes – increasingly, it’s a term that gets thrown around. But for the most part, it only really happens in the Scandinavian countries. And they eat 6 month old rotted shark up that way, so it doesn’t really count.

What is a Negative Interest Rate?

Conceptually speaking, we expect a bank to compensate us (when we’re depositors) for holding our money. The bank, as I showed yesterday, has the ability to take our money and turn it into more money, and earn plenty of interest off borrowers. That is how banks roll.

When we enter into a negative interest rate situation, the situation flips on its head. Suddenly, depositors are back to paying the bank for keeping their money. And, more bizarrely (if the rate is negative enough), the banks will be paying borrowers to borrow money from them.

An illustrative conversation:

Depositor: I’d like to place $100 in my account. How much will it be worth in a year’s time?

Teller: Well sir, I’d like to offer you our best possible rate. At the moment, deposits of similar size are attracting interest rates in the 2% region. We thank you for choosing to bank with us.

Depositor: So I’ll only have $102 in my account next year?

Teller: Uh, no sir. We actually charge you 2%. You’ll have $98 in your account if you don’t touch it. But rest assured that 2% is the lowest interest rate around. Wait, no, it’s the highest interest rate around. Barclays is offered 3%. Um, minus 3%. I’m so sorry sir, it’s still confusing for us. We miss the good old days of just paying for your money.

Depositor: WELL WHY DON’T I JUST KEEP IT IN A BLOODY MATTRESS THEN?

Teller: I hear your point, sir. And if I’m honest, that’s what I’ve done myself. But in your case, sir – I think you’d need quite a mattress. Um – also – don’t you need to do transfers to people? Can’t do that from a mattress, sir…

Depositor: …*thinks*…

Depositor Borrower: What if you loaned me the money to make those transfers?

Teller: Sir – we can do that. We’re offering rates of 1%.

Borrower: Go on.

Teller: Well it makes no sense to me. But it seems that the bank will give you a discount when you repay the money. Take $100 today, and you only have to pay back $99 in a year’s time.

Borrower: Hand me a form then.

The Two Types of Negative Interest Rates

“What is a Negative Interest Rate?” is actually a really interesting** question, because the answer to it is: it depends on what type of interest rate you’re talking about. There are two that I have in mind:

  • Nominal interest rates – which are the rates as quoted, and pay no attention to inflation; and
  • Real interest rates – which is the actual interest rate taking into account the impact of inflation.

 
An example:

  1. Let’s say that I put $100 in the bank, and it offers me 10% interest*** every year.
  2. At the end of the year, I have $110 in my bank account.
  3. But am I really $10 richer?
  4. Only if everything costs the same as it did at the beginning of the year. But that’s unlikely, because all governments like to have a small amount of inflation in their economies. So let’s say that everything is 3% more expensive, which means that I’d need $103 to buy what I used to buy a year ago for $100.
  5. Therefore, I’m actually only $7 richer, give or take some math. Thus, the real rate of interest is closer to 7%****.

 
So in the Eurozone situation:

  • a negative nominal rate of interest occurs when Mr Draghi announces that it’s negative.
  • a negative real rate of interest occurs when the Eurozone inflation rate is higher than the nominal rate of interest.

 
The Eurozone inflation rate in April 2013 was 1.2%. And that inflation rate been above the nominal rates of interest quoted by the ECB for ages. So all the hype about negative interest rates? Well – they’ve been having it. And it’s nothing new.

Why Would a Central Bank Allow Negative Interest Rates?

Because they’d like savers to stop saving and spend; and because they’d like borrowers to borrow more money and spend.

The more people spend, the more manufacturers need to supply. And when manufacturers make more stuff, they hire people. And those previously-unhired people now have jobs with salaries and they can start spending. Which is nearly the definition of Keynesian economic growth.

But isn’t that a bit superficial and/or unsustainable? Using debt to fund growth?

That is an excellent point.

Why yes. Yes it is.

But carpe diem.

*European Central Bank

**Forgive the pun.

***The bank always quotes “nominal” interest rates. In fact, that’s where the adjective “nominal” derives from, as in: the “quoted” or “named” interest rate.

****The math:

(1 + real rate)*(1 + inflation) = (1 + nominal rate)

(1 + real rate)*(1 + 3%) = (1 + 10%)

real rate = 6.8%