Understanding Negative Interest Rates

When the central banks of three European countries and the European Central Bank (ECB) itself introduced negative interest rates (NIR)  in mid -2014, many considered it be a temporary measure, a new experiment in monetary policy. But when the Bank of Japan did the same in January 2016  and when the ECB  pushed rates further into negative territory in March 2016, the international investment world stood up and took notice. Policy makers are now prepared to test this unconventional technique in an effort to stimulate growth and tackle deflation.

The financial press is full of articles on the dangers of this policy. These unconventional moves have provoked a lot of criticism, especially from the banking community who fear a strangulation of normal banking activities. A lot has been written about the dangers that NIR  pose to the stability of banks and to the possible harm to savers and investors alike. This article is an attempt to put the whole question of NIR into a more balanced perspective. To begin with, it is important to have some background to why and how NIRs have come to characterize so much of government debt.

How Pervasive are NIRs?

 According to the JP Morgan international bond index, approximately 25% of its government bond index is in negative territory ( see Chart1). More importantly, the size of that market has grown rapidly and dramatically from zero in mid- 2014 to more than US$6 trillion today.
 

Table l lists the countries whose official central policy calls for NIRs and whose interbank lending rates are negative. The interbank lending rates are a measure of how willing commercial banks are prepared to lend to each other on a very short term basis. In Europe, alone, nine countries’ interbank lending rates are in negative territory.

Initially, the sub-zero debt instruments were confined to the very short end of the yield curve. However, as Chart 2 reveals, NIRs have been extended to the middle and longer ends of the yield curve. In Germany, sub-zero rates extend up to five years and, in Japan negative rates extend out to 10 years – the Japanese 30-year bond trades at a mere 0.50 percent. It should be emphasized that, although the central banks set only bank policy rate, the market place determines all rates along the yield curve from 2 years to 30 years. Clearly, the goal of lowering long-term interest rates has been achieved in Europe and Japan. It will take an extraordinary shift inflationary expectations to eliminate negative rates this far out on the  yield curve.