The Implications of Negative Interest Rates

Jonathan Cummings
Ryan heath
Dan Cowan

To begin, when an economy is not doing so well, the basic strategy for the central banks
is to decrease and cut interest rates. This strategy is practiced in hopes to increase the struggling
economy. Boosting the economy is the main target for cutting interest rates and also encourage
bank lending to boost inflation. The bank lending can increase because it makes borrowing
money look better than saving money because of these low interest rates. Cutting interest rates
have been getting a lot of global attention that last few years and especially this year alone. This
is because central banks have started to cut interest rates so far to start exploring in the negative
level.
A negative interest rate is just what it seems, an interest rate that is set below zero. When
a negative interest rate is put into place, an individual is paying the bank to hold on to their
money instead of the traditional way of the bank paying them on their money being saved. But,
an important thing to point out about this is that a negative interest rate is not referring to real
interest rates, these are nominal interest rates that are set below zero. Just a few years ago this
would of seemed very strange and something that would not happen because of the zero lower
bound. But, many large central banks are now experimenting with such interest rates such as: the
European Central Bank, Denmark, Switzerland, and most recently the Riksbank in Sweden.
Negative interest rates are sweeping across Europe in an attempt to boost the economies.
But, the real question is will these actually help or make things worse. Our paper will take a look
at multiple articles, not only to get a better understanding of negative interest rates, but also to
look at how countries are trying to better their economies by implementing these rates. What we
have come across is that, essentially, theses negative interest rates can be considered almost signs
of desperation for economies. Negative interest rates prove to be a signal that traditional policy
options have proved ineffective and new limits need to be explored (Bloombergview). So, will
these negative interest rates fail continuing the path towards deflation or falling prices that could
prevent recovery, or will it prevail and help boost and stabilize these economies? An issue with
this question is that whatever happens, only time will tell. Since negative interest rates have
never been explored before, no one can really be absolutely sure how economies will be affected
by such a change and that is what makes this an interesting phenomenon. So, this has the
potential to be extremely groundbreaking for the good or for the bad.
To help get a grasp on what is happening with negative interest rates, we set up a rather
simple framework for our research. To start, we looked at main financial articles to see who
suggested if negative interest rates would work or would not work. In this first search, we found
that the majority of these articles were to suggest that negative interest rates were something that
should not be attempted to help solve deflation issues, as stated below from The Economist about
the dangers. Next, we were to look at who was actually implementing these rates right now. We
found out that the majority of these rates were being implemented in Europe. A lot of
information gathered is dedicated to what is happening with the economies that are dealing with
these right now. We wanted to know if they were actually helping and how individuals were
responding to these changes. Although the United States are not dealing with these rates, we still

wanted to look at what was happening in our country compared to what is happening with the
countries using these rates in Europe. So, we gathered information on what could potentially
happen in the U.S. and how negative interest rates could affect our economy.
There were two articles in particular that really helped grasp and understanding of
negative interest rates with the deflation of economies. Both of these articles were from The
Economist. The first one is titled Feeling Down which discusses how deflation could
potentially be something good but how this ear of deflation can be very harmful. This article
explains that there are essentially too many moving parts going on in many economies, meaning,
that prices are falling in too many place as once. Deflation seems to be occurring all over the
map and this article explains the dangers of negative interest rates mixing with this. The second
article The high cost of falling prices from The Economist takes a deeper look at what areas are
experiencing deflation and by how much. Furthermore, the article takes a closer look at Europe
and more specifically explains the decrease in consumer prices there.
One of the biggest problems right now that is happening with many economies is the
event of having low inflation. The Economist quotes this phenomenon as the world is
grievously underestimating the danger of deflation (The Economist, Feeling Down). The
Economist goes onto explain four main dangers that deflation poses. The first one involves the
fall of prices. With this continuing to happen, the consumers are not going to buy things until
they get them for as low as possible. As this happens, demand for products will also continue to
decline. A second danger goes hand in hand with the falling prices. That is because if prices
continue to fall with employee wages continue to stay the same, the process of laying employees
off now becomes a factor. The Economist specifically points out that these dangers are not upon
us yet, but they are just possibilities of would the future could bring. The third danger that is
mentioned is debt deflation. This is the process where collateral used to secure a loan decreases
in value, such as a mortgage. This becomes a major problem because the debts become difficult,
as the amount that is owed does not decrease even though the earnings do. This is something that
has not been really dealt with in the U.S. but it is becoming a large worry in Europe where banks
have already had to deal with these so-called dud loans. The last danger explained is something
that is already here and is the most dangerous. When deflation occurs, monetary policy becomes
harder to deal with. The Economist states When inflation is at 4%, the central bank can take real
rates well below zero by keeping headline rates at zero. But as inflation falls and turns negative,
low real rates get harder and harder to achieve-just when you need them most. Most rich world
central banks have already cut their main policy rates near zero in order to pep up demand (The
Economist, Feeling Down). This is where the negative interest rates are coming into play. In
order to try and boost the economy and demand, countries are using these negative interest rates
to encourage spending.
Furthermore, we found another great article from The Economist written in February. The
title of this article is The high cost of falling prices. The title is a subtle statement that goes on
to explain how the decrease of prices is hurting economies. This articles main point is to grasp at
the understanding of how low and negative inflation can cause more harm than good. The chart
presented below on the left just shows how deflation is affecting the areas of China, Britain, the
U.S., Japan, and the Euro area. All of these areas are experiencing deflation with the Euro area

being the only one in

the negative as of
right now. Potentially,
as more of these areas
continue to
experience negative
inflation, we could
see them experiment
with negative interest
rates just like the
Europeans have.
Furthermore with
Europe, the chart on
the right shows the
Euro area consumer
prices for energy, good, and services. This is a closer look and breakdown of what is going on in
the Euro area that is causing them to experiment with low interest rates. As the era of negative
inflation occurs, new ideas must be developed to correct them, such as, possibly, negative
interest rates.
Europe is currently in a situation in their economy where they have now started to have
negative interest rates at their financial institutions and also Government bonds. Essentially, this
is a position in which the depositor is now, in a predicament, where they are actually paying the
bank to hold their money rather than the conventional way, of a bank paying an interest rate to
the depositor to put their money in their bank. In June of 2014, Europe Central Bank imposed a
-.01% on their deposits and then further lowered it by .01% in the fall of that year. Europe is not
the only place now going to these rates, as we saw Finland and Switzerland also joined in on
negative interest rates. So a question would be why are negative interest rates relevant? The
answer lies within a speculation that it will help their economies. Banks work in a manner where
they want people borrowing money, so if deposit rates are low, it creates borrowing to look more
attractive. Which is how most institutions look at it, however this is causing some people to pull
money out of the banks and keep them in different areas, or even just keeping the cash rather
than putting it in the bank, this creates the obvious problem of them not having money on deposit
to lend out on loans to potential borrowers. The main issue that seems to be causing negative
interest rates is the added pressure of deflation in those economies. Deflation causes prices to
drop and real interest rates to rise, in order to counter this affect European banks are opting to
try negative interest rates. Whats interesting about this situation is banks are trying to counter
the effects of deflation but they might actually cause worst damage. As stated the negative rates
are causing some consumers to withdraw money which leads to less money available to lend, this
will cause a shortage in funds to loan out, and will in turn cause loan rates to increase even more
and become less appealing. The effects of this could be highly damaging to an economy. All of
this is a result of the European central bank going to negative interest rates and also Government
bonds hitting negative interest rates. By the European Central bank having a negative interest
rates it forces banks to either bite the negative rate they are now receiving or pass it on to its
depositors, which is what they chose to do. The Government bonds hitting negative interest rates
causes banks that use government rates as benchmarks to also see the effects of negative rates.

For those banks who do not wish to partake in the negative interest rates due to potential
loss of deposits, well they are being hit in different ways. For instance most banks have assets
that are correlated to market interest rates. If they start going negative like they have been, it will
start causing significant profit loss and depreciations for those institutions. These types of losses
are not easily fixed. A great example I found was Mortgages in Europe, some banks are actually
now paying its customers a fixed rate to have their mortgages through them. This thought is
somewhat crazy, however its true, and it is currently happening in Europe. This problem lies
within government bonds. In a bid to fix their own Financial crises European government issues
bonds which banks couldnt buy enough of, they did this to try to push down interest rates the
problem being is it actually pushed them to below zero. Government Bond rates can be a
precedent for Mortgage rates, therefore if those rates fall below zero, then the mortgage rate set
by it will also fall below zero. This incredible scenario creates a situation where banks are paying
their borrower money to have their mortgage. In most of these cases, the institution paid down
some of the principal for that months payment. This sounds great for a borrower and for a
mortgage owners it sounds like the best case scenario, however the lenders clearly have an issue
with paying their customer to borrow money from them so they have taken their own steps to
counter. By giving negative interest rates of their own to depositors it helps level out their loses
but it also deters depositors from putting their money in banks. Essentially these banks are losing
money from negative rates since they are paying their customer to borrow money and are also
now losing depositors because they have imposed negative rates at the deposit level. Both of
these situations pose significant danger to banks and their wellbeing in the Euro areas. Spain is
currently experiencing the most issues as far as mortgage rates are concerned. Portugal and Italy
are also being strongly affected by this phenomenon. The reason these countries are being
effected the strongest when it comes to loan rates, is because their interest rates used for loans
are directly linked to the Eurobor. For a sense of measure over 90% of all mortgages in Portugal
are linked to the Eurobor. And for a monetary figure thats 90% of the 2.3 Million. Bankinster
located in Spain is a bank that is currently paying interest into the principal for their customers
mortgage because their benchmark is tied to Switzerland currency, which has fallen below zero.
This is one example of a bank situation where they are paying in. In response to this dilemma a
lot of Spanish banks are now creating a cushion between the Eurobor and the rates they offer to
ensure no loses for future loans.
Aside from the issues these negative rates create now, it also poses significant problems
in the future of Euro areas. For instance think of the US housing bubble and the issue it created
within our own economy. A lot of people were buying houses because of how easy it was to
attain mortgages and because they thought they could afford them. Now look back at Europe and
how banks are now paying its customer to borrow money for a home. This will cause mortgage
rates to look very appealing and will also cause real estate to go up in price. This could
potentially cause a housing bubble of their own in the future. Another potential problem that was
interesting is the underfunding of pensions. The reason for this is many pensions are tied to the
government interest rates, negative rates would cause pensions to be underfunded and could pose
as a significant issue in the future years to come to retirees. These negative interest rates could
prove very costly in the future of Europe. Europe is trying to use these negative interest rates to
save its inflation problems now but the issue it can cause in the future could potentially outweigh
the benefit it may produce now. If retirees do find themselves in pension problems and Europe
experiences a housing bubble, a far greater problem may be in the horizon for Europe.

Looking past the problems that negative interest rates create with loan rates and interest
rates as well as future problems in the Euro economy it also poses a different kind of issue now,
that is a technical issue. Banks spreadsheets and technology are not equipped to take negative
interest rates into consideration. This issue is causing every type of financial institution in
Finland, Spain, Switzerland and Euro areas to redesign their computer systems, reprogram their
systems and redraft their legal paper work. Spreadsheets need to be adjusted and financial data
need new equations to be able to allow for negative interest rates. Financial markets were not
built to account for lenders paying debtors to take loans and debtors paying creditors to deposit
their money, this is what is causing the technologic issues. Institutions now need to deal with this
problem, update computer systems and software and bight the cost to upgrade their old hardware
to account for the new negative interest rates that were introduced to the market.
Cash has always been a 0% rate in the sense of it didnt cost anything to hold, introducing
a negative interest rate to cash could have various reactions to the economy. Obviously Europe
believes it will be beneficial and hopefully help them combat its recent deflation issues. The only
situation I can think of that would help against the depreciation is if the negative rates caused
investors to market their money out of country which would lead to deprecation in its own
currency however it would also raise cost of imported goods which would help fight against
deflation. Since Europe has introduced negative interest rates, the Euro has fallen 20 % in respect
to the USD. An interesting solution I found comical at first, but then interesting is an idea by
Mike Kimball of the University of Michigan, who suggested eliminating cash all together and
just using electronic money, he stated this would eliminate lower bound interest rates and also
allow central banks to more easily set rates. This type of economy is one for thought but will
more than likely never be implemented. There are other solutions to negative interest rates that
Europe could have used such as buying long term securities to generate money into the system
but these methods were not chosen by the ECBs president, instead negative rates were. Looking
back at another time where negative interest rates were used was back in 2012 by Denmark. In
that instance nothing really happened, and the economy didnt react one way or another. The
2014 occurrence seems a bit more significant and it affects could be felt for years to come in the
Euro economy.
As previously stated many of the European countries have followed suit and have begun
to introduce negative interest rates not only in the banks but in the bond market as well. Of those
countries some include Austrian, Dutch, German, Swedish, Danish, Swiss bonds, Japan, Mexico
and the European central bank. According to the Wall St. journal approximately 16% of JP
Morgan government bond funds of which is the equivalent of 3.6 trillion dollars bonds are
trading at negative interest rates. The goal is to prevent rising appreciation of the currency
compared to another currency. This is a way to combat the possibility of currency deflation. This
lower rate is a new policy tool designed to prevent the inflow of funds, and to increase
borrowing. This is what the quantitative easing has done for the U.S. This is a policy tool to
introduce an arena where consumers begin to borrow and spend. It is important to understand
that commercial banks with negative rates have potential consequences. If lending or borrowing
is good for borrowers in that they will be able to possibly get paid to borrow money then this is
not as good for those who are investing or are attempting to save. Many of the other countries
despite the fact that the currencies are pegged to the euro since the drop in oil prices have seen an
increase in the money market activity. The Eurozone central bank is attempting to increase

borrowing amongst its banks while the outlying countries are attempting to prevent deflation
witch in essence causes more payments. In the long run this hurts the economy because it can
hinder growth. We are begging to see more wide spread use of the negative interest rates for
differing reasons. Another reason for Switzerland to introduce these low rates is because when
the currency price increases it affects exports of the country. If exports become more expensive
for importers to purchase than exports should decrease causing a net loss in G.D.P. for the
country. The Swiss franc is the 3-month L.I.B.O.R. Rate. Switzerland has even had to change its
currency conversion rate to the euro to make it lower due to its appreciation to the American
dollar.
Along with these differing uses of policy tools there can be implications for the U.S.
concerning the negative yield. The U.S. has investments in foreign bonds and has interest in the
foreign currency market. The negative interest rate can have an effect on the U.S. foreign bond
performance for example it may be undermined so U.S. investors may have to find another place
to park capitol. The dollar is currently appreciating and thus may negate the Federal reserves
talks of increasing the rate hikes in the future. Currently the ECB is participating in Quantitative
easing with bond buy backs to the amount 60 billion per month. This bond purchase program
should improve spending. In terms of currency the bond purchase program creates excess
reserves of cash at the banks which is exactly what the Swiss are trying to negate this I turn did
have a positive effect on appreciation for the franc and caused the banks to push the interest rate
even further into the negative. This action will therefore allow for the appreciation of the
American dollar. This appreciation will make imports more expensive to those countries the
dollar appreciates against. As a possible side effect to the negative rates abroad this could affect
U.S. production and employment therefore decreasing gross domestic product and slowing the
growth of the U.S economy. If the Fed is considering raising interest rates in 2015 or 2106 they
may have to continue to keep rates low to offset the negative impacts of other countries foreign
currency exchange. The fed has maintained a 25 basis point interest rate for excess reserves and
is now considering raising it due to increased U.S. economic activity. According to Janet Yellen
cutting below zero Could completely disrupt market activities. As American corporations
receive income denominated in foreign currency income level has dropped due to the increased
price of the dollar. Some countries including Japan among the European countries have adopted
negative interest rates on bonds. Some of the European bonds are negative out to 13 years. This
makes U.S. bonds more attractive. U.S. bonds while still are at record low prices have been
increasing in due to the attractive positive yield. As there is an inverse price ratio from bonds to
interest rates the increase in attractiveness to U.S. bond purchases will raise the bond price and
lower the interest rate. This offsets the quantitative easing program the Fed has set in place.
Current 3-month yields in the U.S. are sitting at zero percent. While the U.S. is fresh from its
recovery of the market correction that occurred late in 2007, the markets have increased in a
monetary influx, and there has been in an increase in overall economic activity. The feds fund
rate however along with the short term yields are still zero and or near zero proving that the fed
is not convinced the economy is stable enough for a rate hike. With the currencies of other major
countries and the bond prices from foreign countries falling it may not take much for the fed to
induce a further reduction in rates to go into the negative. The U.S. money market is much larger
than many of the other countries and is more greatly affected when it comes to foreign bond

investments. It is feasible for the Fed to lower some rates to below negative to offset the pressure
from these foreign countries. It is possible though however that the stimulus in Europe and the
negative rates provided to induce spending could have positive impact on the United States. As
this is all new to the world we must be careful in our research to develop possible outcomes
based on past experience and to delve away from opinion. It will be hard to determine
speculation from probable outcome. It could all work assuming the spending trickles to the
United States. One possibility if negative interest rates were to come to America as we have seen
in other countries is that one would have to invest in longer-term bonds to see a positive return.
As we have seen there are U.S. corporations currently invested in negative interest rates already
such as the case of JP Morgan. Investors will have to bear loss or find new avenues of investment
terms. It is possible that people could hold cash in that holding cash turns a better yield at zero
than a negative profit and people could begin to convert electronic currency to hard dollars.
There are many positives and negatives to having negative interest rates. As we have seen
banks are beginning to pay debtors fixed payments in exchange for getting mortgages through
them. This makes it difficult to acquire depositors as the depositors are essentially paying for the
loans. The banks are in turn losing money they would make otherwise if there were positive
interest rates. There are also more than one way to use negative interest rates other than as a
policy tool to include lowering government bond prices below zero. Many investments are also
tied to pensions as we have seen interest rates can be used to prevent currency prices from falling
too low to help offset appreciation and curb deflation relative to other countries. They also can be
used directly to promote borrowing witch induces expenditure to reignite a stagnate economy.
This does however create the ability to purchase negative yielding government debt in essence
people are paying the government to borrow. With the advent of the financial crisis beginning in
2007 starting in America and the quantitative easing measures the Fed had to take to curb the
market decline, the other countries of the world have felt the dip as well. There has also been the
oil crisis of 2014, which helped to ignite the influx of cash into countries such as Switzerland to
find a safe haven. While yields may be negative investors believe government debt is safer than
corporate debt. Yet the world has seen that even though it may be slow influx of cash can have
positive effect on aggregate demand. There has not been the same amount of investment funds
reinvested in the world market since the correction of 2007. While Fed has not introduced below
zero interest rates corporate America has already felt a loss of income due to the appreciation of
the dollar, which could offset the feds ability to increase rates. The negative interest rate has
varying implications and only time will tell as to how it will effect both short term and long-term
output of the worlds economies.

Work Cited

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http://www.wsj.com/articles/negative-rates-test-technology-at-european-banks1425504420
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http://www.zerohedge.com/news/2015-02-13/goldman-asks-if-negative-rates-arecoming-us