There’s a lot of confusion about negative rates, and I think most of it comes from not asking "negative relative to what"? Most observers define negative rates as less than zero. They make the case that if a bank imposes a negative rate it is a penalty rate when banks charge their customers to hold money at their bank.


And this may be true, but only if the inflation rate is higher than the rate charged. It is real rates that are all important, not nominal rates. Real interest rates are the nominal rate of return minus the inflation rate. If inflation is running at 2% and the bank is offering 1%, a saver at a bank receiving 1% is losing 1%. So, a 1% bank interest rate in this example is actually a negative rate. The same is true with lenders. If the inflation rate is 2%, lenders must charge more than 2% to make a real return.


The exercise becomes even more complicated when calculating interest rates in a deflationary environment. If interest rates on saving accounts is zero and deflation has been running at 2%, you are making a 2% interest rate! The nominal rate of interest may be zero, but if deflation is 2% per year, the money in your savings account will buy 2% more by the end of the year. So the definition of negative interest rates in my book is not “less than zero”, but “less than inflation”.

During the Great Depression the deflation rate at times was running at 8%. The interest rate was at 1%. Therefore the real rate of interest on money was 9% even though at that time interest rates were said to be the “lowest” in history. In reality they were among the highest interest rates in history.  That's why I use the inflation rate as the standard to judge interest rates, not nominal rates. A negative interest rate in nominal terms tells me nothing. It's the real rate that is important.


Today, a lot of monetary theorists are screaming about negative rates distorting the economy, or robbing savers; but if the negative rate is higher than the deflationary rate it is not a negative rate -- it's a positive rate of return.


What's important in all of this is whether interest rates are artificial rates or market rates. I would contend that even though central banks are in control of the short end of rates, most all other rates are market-oriented. The decade-long trend of disinflation moving in some cases into deflation is the main cause of historically low interest rates -- not central bank policy. By the way, this is what Greenspan argued during the mid-2000 decade when interest rates fell to new lows. The Fed raised the federal funds rate and long rates fell! The Fed lost control of rates at that time and has never regained control.


The 4% long term interest rate ten years ago was in a 2% inflationary environment. Today we have a 2% inflationary environment and a 1.5% long rate. So we've moved from a 2% real rate to a minus 1/2% real rate. The market has taken the real rate of interest lower. The US like so many other countries in the world have negative interest rates. In Germany for example, you have a -0.11% ten year rate in a 2.5% inflationary economy. The world has generally moved into a negative interest rate environment. 




In my view it is because of long-term economic stagnation and deflationary fears overriding inflationary fears. The premium on money has dwindled with growth, prosperity, and deflationary fears. The historic return on capital is 3-5%. That's what investors need to compensate them for risk and still make a reasonable return. At a 2% inflation rate, the nominal interest rate, or what we use to call the "prime" rate, should be 5-7%. The savings rate, or what we used to call "time deposits" should be a couple of points under that.


So we have a dysfunctional loan market. And as a result we have a dysfunctional investment market. The upshot of all this is that it is not due to monetary policy. Central banks for the most part have simply followed the markets downward. Abnormally low interest rates are due to stagnation, ingrained low inflation expectations with a deflationary bias, and a historically low demand for money by consumers who are more concerned with paying down debt than taking it on.


The true cause of low interest rates is the replacing of free markets with government intervention. Throughout the world, government control and regulation of economies everywhere have grown to the point where normal human action has been replaced by the dictates of government. Where free markets follow the choices of individuals, governments shun things like self-interest, profit, and personal preference for their own choices.


We have made a transition in the world from global free market capitalism to global centralized decisions. It is only a matter of degree to what extent each nation is in that process. Venezuela is on one end, and America is on the other. But all are somewhere in between, hence global stagnation.


The road back to normalcy is to free up markets and allow individuals to think and act independently and not as a group determined by a bunch of politicians and bureaucrats. The way out of the quagmire the world is in, is to return to freedom. But there is no sign that any such movement is being called for or planned. As a matter of fact, the candidates for the presidency of the United States - the last home of free markets - are for the first time in history both for protectionism and a giant government infrastructure program.


The trend toward socialism and social engineering is not dying -- it's accelerating! A mega-spending program next year will increase our debt, and like Japan will come and go with little increase in the GDP, but massive debt added to the national debt. Inflation is bound to start moving higher. It will be inflation and debt that become the new worries in the future, and then once again recession.


So it's stagflation "lite" today, but serious stagflation to come if we continue to slide into more and more government solutions to problems. Higher interest rates will be the inevitable result. One way of protecting oneself other than gold and silver and resource stocks as a hedge against inflation is a hedge against higher interest rates. For more information on that, see my Market Update.


Paul Nathan