Negative Interest Rates

September 15, 2016 | By Jon Powell, CFP®| Managing Investment Risks

I’ve gotten a lot of questions concerning the concept of negative interest rates. Many seem to wonder how it’s possible for a bank to have a negative interest rate and why it would make sense for anyone to pay to give someone else their money.

Regulated interest rates are a confusing topic to begin with and uncharted situations, like negative rates, make it even more complicated.

What Banks Are Setting Negative Interest Rates?

The first thing to be clear on is what “bank” is being referred to when you see things like this pop up on the news. A central bank is the bank of a country which lends money to other commercial banks.

In the United States, this is The Federal Reserve, commonly referred to as the “Fed”. Commercial banks are the banks that work directly with businesses and individuals such as BB&T or Wells Fargo.

Right now, when you see news relating to interest rates becoming negative, this is referring to a very specific rate which affects the relationship between central and commercial banks, not the interest rate Bank of America is giving to John Smith on his savings account(at least, that’s not the case yet).

At this time, some of the central banks of Asia and Europe have set interest rates to be negative.

Reasons for Negative Interest Rates

There are two primary reasons for a central bank to set a negative interest rate; to devalue its own currency and to encourage investment.

The general idea behind negative rates is to make it unattractive for commercial banks to sit on excess cash. If a bank is losing money by having it idle in their reserves, they should be more willing to lend it to prospective businesses and individuals.

The assumption then is that these business and individuals will use this borrowed money to produce and spend to grow the economy. The economy is very much like an ecosystem and if one part of the chain isn’t functioning normally, everything gets thrown out of balance.

Now, the above isn’t to suggest that negative rates won’t come to the US or that it’s impossible to one day see a negative interest rate on your savings account. However, before we break into hysteria over the possibility, let’s think about what banks actually do for us.

The Service of Banking

As individuals, we store our money in a bank and expect to get some small amount of interest for parking our money there. The banks then use our money, while we’re not, to provide loans and invest.

When we want our money back, the bank usually can honor our request with no problems. There have been runs on banks, most notably during the Great Depression, but overall the banking institution used in this manner has worked reliably for consumers.

When you think about it though, this service of storing our money, is actually a very valuable benefit. Cash is cumbersome. Most people don’t want to walk down the street with several thousand dollars of cash on them.

Stuffing it under your mattress or burying it in the backyard is pretty scary, too. All sorts of perils can befall physical cash. It could get stolen, it could get destroyed, and it could get lost. Furthermore, in 2016, it’s pretty inconvenient to spend and use physical cash.

In a world of online shopping and automatic bill pay, having cash in physical form is pretty inefficient in most cases compared to having it electronically available to you wherever you go.

With the exception of irritating transaction fees or low balance charges, we’ve grown up in an era where banking is “free”, or rather, we actually expect banks to pay us to provide this service.

If we want to think about things on a larger scale than a bank account, we can purchase debt instruments with a negative yield. The idea here is that you are purchasing a bond for more money than you will ever receive back in coupons and payment at maturity. Again, this still accomplishes the service of storing our money for a period in a safer manner than we could with cash.

Storing large amounts of money safely is very difficult. Even in a negative rate environment it may still make sense to use a bank, or in larger terms, purchase negative yielding debt. For better or worse, banks are much better at storing my money than I am, on my own.

Hopefully, this has helped explain some of the idea behind negative rates and why anyone would agree to pay someone to give them their money.

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