The Truth About Negative Interest Rates is Ugly

Dan McCrum’s Insight column in today’s US print edition of the Financial Times is fascinating. You’ll find it on the back page of the Companies and Markets section. It is titled, “Negative rates reverse assumptions about financial decisions“.

Mr. McCrum explains away a basic financial truth about the time value of money. He explains that a given financial truth, the time value of money, results in the idea that money is more valuable today then tomorrow. It seems that we would spend our money tonight on a beer our favorite burger rather than hold on to that money for the same purchase in the future. The reason for this change in value over time is that many things may change between now and that future, such that shorter term gratification takes priority over long term riskier rewards.

To explain how we cope with that difference, we offer interest rates to those that loan money. The change in interest rate explains and accounts for an increase, or decrease, in the reward for carrying that risk over the duration of the loan. This is all basic stuff. It works. But with negative interest rates this basic truth is upside down.

With negative interest rates the value of money goes into reverse. Now the value of that beer and burger is higher in the future.  Your $50 today becomes $52 in the future so your ability to acquire more stuff increases. Switzerland, a central bank to adopt negative rates, is experiencing deflation. The ECB and the euro zone are flirting with negative rates and deflation. Denmark has negative interest rates that now pay you interest on your mortgage.  If you add in persistent deflation, we might even assume a need for increased negative rates to cope!

If this were not enough for you, check out Japan’s Subzero Rates Cast Chill Over Markets on the front page of today’s US print edition of the Wall Street Journal. The article explains how Bank of Japan, the central bank, is flirting with increased negative rates to drive growth, even though the recent shift into negative territory shows now sign of driving growth and in fact is creating unintended consequences. The article reports “Every day is like being Alice in Wonderland. Interest-rate levels are having little effect on credit demand, the market function is declining. You can’t expect everything to go according to plan,” said Tomohisa Fujiki, head of interest-rate strategy at BNP Paribas Securities Japan.

The whole negative interest rate idea creates a fascinating line of thinking. It’s the kind of thinking that leads to new insights. One of my favorite insights of a similar nature concerns the idea that more information improves the quality of a decision: it does not.  

In More Than You Know (one of my favorite books), by Michael Maubouson, then chief investment strategist at Legg Mason Capital Management (2006), there is reference to an experiment with horse racing and tipsters. The experiment showed that as additional information was serviced to tipsters, their accuracy in predicting winners increased. However at some point the accuracy declined and the more data shared with tipsters, the worse their predictions.  

So we should not always assume more data is more useful. Equally we should not assume that what goes by economic orthodoxy remains constant. We are experimenting with large scale negative interest rates and we really don’t know what will happen. Maybe it’s time for something different.

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