I’d like to talk a little bit about interest rates.
Did you know that there is a new Danish mortgage that has a negative interest rate? This almost seems like a dream… Why would a bank pay you to borrow money?
So how can this be true, and why is it the case? Well, let’s look at the broad economics and the three players involved.
Borrowers, Banks, and Central Banks
- The first player or entity we should look at is the borrower. A borrower can be everyday people like you and me who want to get a mortgage or loan, or it can also be businesses or corporations that would like to borrow money.
As an aside, most debt/loans that are borrowed for business-purposes is to help that business grow, and not to pay back other debt.
- The borrower goes to the second player, normally a bank or financial institution, for their needs. The bank charges the borrower interest on the loan and facilitates the transaction. When deciding who gets what loan, each bank or financial institution must decide whether the borrower’s request is at an appropriate risk level for them to approve. This is exactly the case where a bank has to make sure that a person can pay back their mortgage based on the income that borrower has.
- Now, did you know that the banks (catch all here for banks and financial institutions) don’t always lend their own money? Banks are able to borrow money from the third player in this hierarchy: their country’s central bank. In Canada, the CB is called the Bank of Canada and in the United States called the Federal Reserve. The banks are able to borrow from their central bank at a lower interest rate than the rate that the bank charges the borrower. The banks earn their “spread” on this money (the difference between how much the CB charges them, and how much they charge their borrowers) so they can earn a profit, but also to pay for their administration costs.
Phew – so now we know the three players.
But why did the second player, a bank in Denmark, pay borrowers to borrow money…? The answer is simple: the central bank of Denmark, or Nationalbanken, is paying the banks even more money to borrow cash than what the banks are paying their borrowers.
The Economy and the Central Bank
You’re probably scratching your head as to why this occurs…
I mean, why and how would there be negative interest rates?
Would it surprise you if I told you that Japan has had interest rates at 0% and negative rates on deposits for some time?
Quick Info: A deposit is any money you have in your bank account that is not used for investments. Savings and chequing accounts are deposit accounts. A deposit can be deemed as the exact opposite as a loan. If your savings account is negative 1%, and you have $100 in your account, at the end of the year you will be left with $99. On the other hand, if you take out a $100 loan with a negative 1% rate, you will only have to pay back $99 at the end of the year because you effectively made $1 for keeping that loan.
When the Japanese banks offer negative rate bank accounts, they are effectively telling consumers: “Do not leave your money here; go out and spend it.”
And why is the Japanese bank telling their clients to spend money and not save? It is specifically because the 3rd player in this debt machine, Japan’s central bank (The Bank of Japan) has 0% or negative interest rates.
A country’s central bank’s main role is to form and implement monetary policy to influence the country’s money supply (central banks are the issuers of bank notes; the Bank of Canada is in charge of printing our currency and deciding how much currency to print), the overall economy, and by extension, inflation/deflation.
And, the economy is what prompts the central bank to increase or decrease their interest rates. A rising or growing economy would prompt the central bank to increase rates and a contracting economy would force the central bank to decrease borrowing rates.
Secondly, if the economy is doing well, specifically if the job market is positive (low unemployment) and businesses are investing and growing, that country’s average worker wages will increase. An increase in wages means more buying power, which means more demand for the same goods, leading to higher than expected inflation (many central banks allow for inflation of around 2% per year).
As an aside, the opposite of inflation is deflation.
Inflation means that the economy is growing too rapidly and in order to stem that tide, the central bank will increase their interest rates, prompting the banks to increase their interest rates, and lastly affecting (most importantly) businesses borrowing for growth. Remember how businesses borrow money to invest and grow? Well, the more expensive money is to borrow for businesses, the less they will borrow and less they will invest, effectively dampening economic growth.
On the other side, if the economy isn’t doing very well, the central bank will want to decrease interest rates in order to allow businesses to borrow at lower rates in order to spur investment and company growth. Company growth means more hiring, higher wages, and a better economy.
Yes, there are other factors that affect monetary policy such as currency price fluctuation and how one country’s change in currency value vis-a-vis other countries affects their imports and exports. However, the main culprit for a central bank’s increasing or decreasing of their interest rates is due to the economy and inflation.
So, long story short (in one sentence), as the economy grows or is expected to grow, the central bank will increase interest rates to avoid inflation, and if the economy is contracting or is expected to contract, the central bank will decrease rates.
Back to Denmark
Based on all of the above, Denmark’s central bank isn’t worried about a runaway economy, but they are worried about stagnation and a contracting economy.
Let us know what are your thoughts in the comment section below!