Ever since the financial crisis, interest rates in all the major western markets – The US, UK and Eurozone – have been near zero. Most recently, the ECB took its main deposit rate into negative territory to try to stimulate the Eurozone’s sluggish GDP growth rate. With the US Federal Reserve mentioning the concept in passing at the last FOMC meeting, indications are that policymakers are priming their stimulus stoves with this particular ‘accelerant,’ although they are not saying it’s going to happen.

What does it mean for a central bank to introduce negative interest rates? During periods of slowing economic growth, companies – and people – tend to seize up, hoarding money instead of spending it in the economy. Negative interest rates implore retail banks to lend money rather than holding it in deposit – for which they must pay. They are bad for retail banks because, typically, the banks will pay the costs associated with negative rates and not pass these on to depositors for fear they’ll convert those deposits into cash. That eats into a bank’s profits.

Negative rates reduce the cost of borrowing for companies and people, and so increase demand for loans. That leads to growth, job creation, increased spending in the economy and, ultimately, heaven.

Negative interest rates are often confused with the term ‘Quantitative Easing (QE).’  QE is a method of lowering interest rates in which a central bank floods the economy with money by buying up government and corporate bonds. When demand is high for government bonds, the price goes up but the yield goes down (price and yield move opposite to eachother).

The yield on government debt essentially translates to the short term interest rate, and so the short term interest rate goes down. Furthermore, lower yields are less attractive than higher yields. Foreign investors don’t want the bonds, so they don’t purchase the currency with which to buy the bonds. Demand for the currency goes down and the currency weakens – a good thing for companies that export goods.

As interest rates approach zero, the central bank could extend to buying corporate bonds – those of the banks and other large corporations. This injects masses of cash more directly into the economy, encouraging investment in growth hence job creation. At the same time, banks whose bonds have been bought by the central bank are encouraged to lend their increased funds. The economy is awash with cash, everyone’s got a job and they all go out and buy miniature Tiffany Favrile vases and Porsche 911s.

Of course, there are associated risks with QE. The first is runaway inflation (we should be so lucky), since the amount of goods for sale remains the same while the amount of money available suddenly rises. Simple supply and demand. Secondly, well, the banks just might not play the game. Interestingly, after almost 1 year of ECB QE, inflation in the Eurozone is negative at -0.2% (at time of writing) while banks have simply been parking their excess funds at the ECB overnight rather than lending it to peers and others.

It seems that fear number two, in the case of the Eurozone, has materialised. That’s why the ECB adopted negative interest rates in 2014. In doing so, it adopted a ‘use it or lose it’ approach to those wishing to stash their cash overnight. Problem is, after 2 years, not much has changed. While we’ve seen stock markets rally strongly since the crisis to shower the Warren Buffets of this world with healthy returns, it hasn’t really worked for Joe Public so far. Stock markets have gone up, but economies are lagging in comparison.

Now, with the ECB potentially about to send its overnight deposit rate even further south, we find ourselves asking why such an approach should be successful now, when prior attempts have essentially failed.  Here’s our alternative!

Augustin Eden, 7 March