What are negative interest rates?
Negative rates happen when central banks aggressively ease monetary policy, setting their benchmark rate below zero, so that other banks have to pay to store their money instead of receiving interest on their deposits. The idea is to make storing money at the central bank less appealing and encourage banks to deploy their capital into other investments to stimulate the economy.
It’s not a great scenario for commercial banks, whose costs go up and margins shrink, but dropping into negative territory is an option central banks can use when the economy is sputtering and they’ve run out of options.
What’s the danger of low rates?
It’s important to remember that central banks adjust interest rates to manage economic growth and inflation. Planned decreases and increases are typically telegraphed well ahead of time and priced into the markets.
But when central bank rates are historically low, as they were after the 2008 financial crisis, the monetary policy gun is left with few bullets in its chamber – which is dangerous if the bank needs to pull the trigger and lower rates to stimulate the economy.
If rates are already very low when the U.S. Federal Reserve or Bank of Canada need to lower them again, they’ll end up in negative rate territory.
Europe and Japan found themselves in that scenario, and markets didn’t immediately respond with increased lending and spending.
That leads to concerns that when rates have been so low for so long, and money has been so cheap, monetary policy could risk losing its effectiveness.
In Canada, interest rates are low but nowhere near (or past) zero. In 2019, the Canadian overnight rate sat at 1.75 per cent.
But I get uneasy around the discussion of negative rates, especially when they appear to be tied to slowing global growth and trade wars, because that raises the question of whether central banks are penalizing other banks for holding cash, in order to encourage capital spending and economic growth.
I wouldn’t expect zero or negative interest rates to appear in the retail environment (mortgages or car financing), but allocation of investment capital can become distorted and impact risk-adjusted returns.
