The lowdown on negative interest rates

Here’s my humble attempt to explain the logic of “negative interest rates” over at Enhancing Capital. I’ve found some good stuff written on this topic already, but nothing that I thought was accessible to the average person. Hopefully this report helps to fill that gap.

One highlight I’d like to point out is that negative interest rates on reserves at the central bank aren’t necessarily a “game changer.” They do reverse the logic of interest on reserves (commercial banks pay interest to the central bank instead of the central bank paying interest to commercial banks), but they don’t mean that banks are all of a sudden going to try to get rid of all their reserves. This hasn’t been the experience of banks in the Eurozone, where negative rates already exist on some deposits at the ECB. It won’t be the experience of banks in the U.S. if the Federal Reserve takes similar measures. Finance is all about trade-offs—paying a small fee to hold reserves at the central bank could still be a more attractive option to commercial banks than making more loans to keep their negative interest-bearing reserve balances from growing. What matters is whether commercial banks can identify enough credit-worthy borrowers whose risk of default is low enough to promise a higher return than the negative interest rate charged by the central bank. If not, then banks might very well be content to pay interest to the central bank rather than make more loans.

Finally, I realize this report might seem mistimed. If anything, talk on the town regards when the Fed is going to tighten monetary policy, not loosen it. My explanation is three-fold:

  1. I’m not convinced tightening is as imminent as many analysts are making it out to be, for reasons I’ve explained before.
  2. It’s important for investors to understand the logic of negative interest rates before they happen, not after (no harm in being over-prepared!).
  3. The ECB has already imposed negative interest rates, and the Bank of Japan has toyed with the idea. The policies at these banks, of course, have ramifications worldwide, and investors everywhere ought to understand what negative interest rates are.

Read the full report at

Bundesbank: No QE even with sub-zero inflation

Reuters is reporting that the Bundesbank head Jens Weidmann is skeptical of further QE in the Eurozone, even if the inflation rate drops below zero. In his own words:

Against the background of the rather moderate and uncertain impact as well as the risks and side effects and the not clearly given necessity at the current point in time, I am currently sceptical of a broad-based QE programme. … Substantial volumes would be needed to achieve a moderate and moreover uncertain impact.

This is especially interesting in light of a survey released yesterday showing that 90 percent of respondents in a Bloomberg survey predict the ECB will restart QE next year. This is up from 57 percent the previous month, before oil’s price collapse had become so drastic.

Draghi and Weidmann have sparred for quite some time over the need for more easing. Weidmann’s conservative stance arguably represents the popular opinion among Germans, whose economy has not suffered as deeply as smaller European economies. But Draghi seems to have won this bout—the possibility of a new round of easing has already lured investors into European equities, which would make squashing these expectations a nightmare for already-ailing European markets.

On a related note, here’s a post by Scott Sumner on the ECB. He asks whether the ECB is a hopeless case. He stops short of answering the question outright, but I think we can see where this is all headed.