Understanding the chatter around negative interest rates
On Friday, March 13, 2020, the Bank of Canada cut the overnight rate by half a percentage point to 0.75%. It was a shocking move in a way, given that the BoC just cut rates by 0.5% a week earlier, but it’s clear that they think COVID-19 could be far more damaging to the Canadian economy than they initially thought. Bank of Governor Stephen Poloz also said that he would cut more if need be.
But how low can rates go? In 2008, the BoC cut its overnight rate to an all-time low of 0.25%, so another 50 basis point slash would bring it to that level. However, back then, rates started at a much higher level–around 5%–so the BoC was able to slash more than it can now. In theory, if the bank had to cut beyond 0.25%, it could go to zero rates or even to negative rates.
Many Canadians likely haven’t heard of negative rates, but now’s the time to familiarize yourself. Here’s a primer on below-zero rates.
What are negative interest rates?
There are a couple things to know before we answer that question. First, the overnight rate, which is an interest rate banks use when lending to one another for one night and which the central bank controls, forms the basis of lending rates. Everything from mortgage rates, lines of credit and auto loans are based on this rate, which, in Canada, is currently at 2%. It can also impact bonds—if the overnight rate falls, yields tend to fall, too.
Second, interest rates are used by central banks to either spur or cool economic growth. Lower rates encourage people to borrow money, which they then use to buy stuff. Those purchases help the economy grow. If the economy gets too hot and people start worrying about inflation or asset bubbles in, say, housing, the central bank would raise rates to discourage borrowing.
Negative rates happen when central banks cut their overnight rate to below zero.
Going negative seems like a drastic measure. What’s the point?
Many financial institutions, which have millions or billions of dollars, store their excess cash at central banks for safekeeping. Normally, those institutions earn a small return on those funds, but in a negative rate environment, the banks get charged by the central bank for storing dollars. That increases the institution’s overall costs. It’s not that the central bank wants the money; rather, they’re penalizing banks for hanging on to their cash instead of lending it out. They want people and businesses to borrow more—at ultra-low rates—which should then help buoy economic growth.
Why are we talking about this now?
On September 11, President Donald Trump tweeted, “The Federal Reserve should get our interest rates down to ZERO, or less.” So that’s one reason. But more importantly, with trade wars slowing global growth, central banks are cutting interest rates again. The U.S. Federal Reserve reduced its interest rate twice this year, including last Wednesday, when it cut its overnight rate from about 2.25% to about 2%. Since rates are so low right now—most developed nations’ central banks dramatically slashed rates after the recession and haven’t increased them back to their pre-recession levels—there’s not much room to manoeuvre in tough times. If the economy gets bad enough, it’s conceivable that the U.S. and Canada could cut so much that rates end up in negative territory.