Thursday, July 12, 2012

Negative Interest Rates?

How much fear is there regarding the European Debt Crisis?  Here's a chart of the two-year German government bond (note the yield was -0.04% as of July 12):

And here's a chart of the two-year Swiss government bond (yield = -0.36% as of July 12):

In fact, the yield on Swiss five-year government bonds are -0.01% as of noon EDT on July 12.  Of course the primary reason for the negative yields is the desire for a safe haven (return of money instead of return on money).  However, as mentioned in an article in Bloomberg today, the recent reduction of the interest on reserves by the European Central Bank prompted banks to purchase the short-term government bonds of the safest European countries.  For those who don't know about interest on reserves, the ECB (and other central banks) pay interest on funds that banks keep at the central bank.  In order to get banks to "use" the funds instead of storing them at the central bank, the ECB announced that the interest rate was going to be reduced from 0.25% to 0% effective today.  How did banks respond?  They shifted some funds from the safety of the central bank to the safety of short-term government bonds of the safest countries (safe means not Spain, Greece, etc.).  What does this imply for the Fed policy?  Some have suggested that the Fed should also reduce the interest on reserves from 0.25% to 0%.  The actions of banks in Europe suggest that American banks would probably also move some of the funds to "risk-free" assets instead of increasing lending throughout the economy, thus limiting the stimulative effect of such a policy.  Advocates of a reduction in the interest rate on reserves would state the lower interest on safe assets would push lenders and savers into somewhat riskier assets, which could provide some stimulus to the economy.  This is a similar argument that's made for other forms of monetary stimulus recently.  Unfortunately, the effects are likely to be minimal.