Monday, January 12, 2009

Negative nominal interest rates

We've heard of negative real interest rates (RIR) when the interest rate is below the inflation rate. Borrowers like a negative RIR as the real value of their debt is falling. For the same reason savers dislike a negative RIR as the real value (purchasing power) of their savings is declining; prices are rising faster than they are earning interest.

But what happens when the nominal interest rate (NIR) is negative. When depositing money at a negative NIR it is like paying a storage cost. This has already happened.

From an NYT report of a December US T-bill issue:

Investors accepted the zero percent rate in the government’s auction Tuesday of $30 billion worth of short-term securities that mature in four weeks. Demand was so great even for no return that the government could have sold four times as much.

In addition, for a brief moment, investors were willing to take a small loss for holding another ultra-safe security, the already-issued three-month Treasury bill.

In the rush to safety investors were willing to pay the US Treasury to store their money. Would financial institutions be willing to give their money to everyday people to store? This may be about to happen in the UK mortgage market.

It seems likely that mortgage rates for some customers may turn negative in the next few months. This will happen because in the rush to lend money of the last few years some lenders offered tracker mortgages at fixed margins below the Bank of England's base rate. See BBC report here.

These offers were only available for a short period and the most generous of them was Cheltenham and Gloucester's BOE - 1.01%. With the base rate at 1.50% another 50 basis points fall means that the interest rate on these mortgages will be negative. Cheltenham and Gloucester will be paying interert to those customers who are on this rate. It is as if they have given the money to their customers and are paying them storage costs.

If the BoE decide to follow the US and move to ZIRP (zero interest rate policy) the mortage rate on these mortage will be minus 1.01%. A borrower could pay off a quarter of their mortage in 25 years by doing nothing!

Of course this won't happen as

  1. The banks haven't announced what they will do if this situation arises so they may find some small print to prevent the negative mortgage rates.
  2. These were only introductory offers that have a fixed period the longest of which is three years. After this period the loans switch to the banks' standard variable rates. Rest assured these will never be zero.

Still it highlights just how unexpected this financial crisis or "credit crunch" was. These loans were offered in July 2007 just weeks before the turmoil began towards the end of that summer.

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