[PULSE] What is a negative interest rate and how does it work?

[PULSE] What is a negative interest rate and how does it work?
Despite the Federal Reserve chairman’s aversion, negative rates increasingly possible, but not negative mortgage rates – yet.

With central banks lowering interest rates to all-time lows, investors flooding into safe investments driving prices up (and yields down), and the need for unconventional fiscal and monetary stimulus, there’s talk of negative rates.

While initially unintuitive, negative interest rates work similarly to their positive counterparts.

For example, if the Federal Reserve’s benchmark rate – the Federal Funds rate – were negative, banks would pay that percentage of their deposits to the Fed for keeping them. For a consumer at a regular bank, their deposit would shrink as interest is paid to the bank over time.

Finally, imagine an investor desperate for a safe investment, like a Treasury bond: they may pay a price so high that the cashflows end up being less than what they paid for the bond, a negative yield. 

Have negative interest rates and yields happened before? Why?

Guest AuthorBrendan Phillips

In short, yes. While Denmark was the first to implement a negative policy rate eight years ago, both Europe and Japan’s central banks now have negative deposit rates. In addition to negative reserve rates, there’s $15 trillion of negative-yielding government bonds in Europe. Negative-yielding debt is not new, but as investors flock to safe investments during recent volatility, that amount has increased. Negative rates were hoped to spur lending and borrowing to kickstart these economies, with some success in Europe but mixed success in Japan.

Could negative rates happen in the U.S.?

Though the Federal Reserve Chairman Jerome Powell has said he doesn’t see negative policy rates as appropriate for the U.S., traders are betting on the slight possibility of a negative Federal Funds rate in the next year. The more dire the economic situation, the more likely negative rates become. In a U-shaped recovery – a longer period of depressed economic activity than a “snap-back” V-shaped recovery – consumer confidence would be low from lost income, consumption patterns could be dampened due to health concerns even after states reopen, and people would be more prone to save rather than spend money. But debts would still be increasing while the demand for goods and services doesn’t pick back up. 

To cushion this economic fall, fiscal stimulus – i.e. government spending – has been needed so far. The federal government has spent over $4 trillion dollars, with plans in the Senate for another even larger stimulus package gaining traction. As a result of spending thus far, the CBO predicts the debt-to-GDP ratio will reach 108% by the end of 2021, smashing a record of 106% shortly after World War II. With prices of oil, housing, consumer goods and many other economic inputs falling, deflation is another risk the government is facing along with depression. 

Faced with the twin threats of deflation and depression, the Federal Reserve has decided to purchase U.S. debt in the form of Quantitative Easing (QE), meaning the central bank will create money and use it to buy Treasury bonds. This has the effect of increasing the supply of money in circulation and decreasing interest rates throughout the economy: two forces to combat risks of deflation and economic stagnation. The government’s spending is effectively forcing the Fed to print money to buy the debt the government creates, known as “monetizing the debt.” Some economists argue this arrangement, designed to push interest rates down, is the precedent to and logical step before, negative interest rates. The mechanism has lowered rates in Japan and Europe, with Japan’s policy rate negative for the last four years. 

What happens to mortgage rates then?

To most mortgage borrowers, it would be mind-boggling to pay part of their principal, with a negative amount of interest making up the difference, but that’s precisely what happened in Denmark’s negative rate environment. One Danish bank began offering borrowers a 10-year deal at -0.5%, with another offering 20-year fixed-rate mortgages at 0%. According to the banks FAQ (in Danish), they are able to offer this rate by borrowing money at even lower negative rates from money markets. While other countries haven’t seen the drastic step of negative mortgage rates, Japan’s have been under 1% for four years. Such rates are designed to make it less attractive for consumers to save money and more attractive for them to invest it to spur economic growth. 

It’s unlikely, however, anyone in the U.S. will see negative mortgage rates soon. In Denmark, mortgage rates went negative seven years after policy rates, meaning lenders were certain they could borrow at negative rates and pass them on to borrowers. The difference between the rate lenders borrow at and the rate they can lend to consumers at represents the risk they take on. Risks of default, interest rates moving and early repayment of the mortgage all factor into the premium paid to lenders to assume the risk of a mortgage. The spread widens in recession as these risks become higher.

Denmark’s mortgage market has special features that mean lenders assume less risk, allowing them to offer negative rates, but such mechanisms don’t exist in the U.S. If U.S. policymakers decide negative interest rates are necessary, lenders will probably be assessing the risks associated with making mortgages to be much higher than usual, meaning that negative mortgage rates in the U.S. are still a very distant, mostly theoretical possibility, even if mortgage rates do decrease.
The post [PULSE] What is a negative interest rate and how does it work? appeared first on HousingWire.
Source: https://www.housingwire.com/rss