Intentional Finance

Week 1

1. Do you think that negative nominal interest rates will have the desired effect of preventing deflation (and boosting inflation), and lifting economic growth?

It is unlikely that negative nominal interest’s rates will lift economic growth and prevent deflation. As cash carries an implicit interest rate of 0% consumers may respond to negative rates by withdrawing money and storing it in their ‘mattresses’. This is however unlikely to happen as storing money is risky and costly for savers. Negative rates are more likely to cause financial instability in other ways. Banks and building societies are unlikely to pass on negative rates on to depositors as they may lose customers to other financial institutions. This combined with the fact that a key source of income for these types on institutions is a return on their assets and that this is also likely to vary with interest rate, resulting in lower profits. Lower profits will eventually lead to an erosion of capital and damaged financial institutions are unlikely to power economic recovery. The move to negative interest rates also sends a powerful signal to the market. The market and consumers may either interpret the move as a clear indication that nothing else is working and that this is measure of last resort or inspire confidence with the fact that the central bank is very serious about talking deflation. With the market likely to interpret the move in different ways and the stock prices of banks likely to fall due to this uncertainty, a further squeeze is the market is likely.

2. What are the dangers associated with negative nominal interest rates?

3. Unlike official interest rates, which are of course set by central bankers, bond yields are market-determined. Why do you think that some governments’ bond yields are negative? Why are Japan’s 5 and 10-year bond yields negative?

A bond has an inverse relationship between its yield and price. A bonds yield is usually reflective of its level of risk. For example, a bond that has higher risk needs to be compensated for that risk with a higher yield. Alternatively, the safer a bond is the lower its yield is and government bonds tend to be the safest form of a bond though this is highly dependent on the country. Japan’s 5 and 10-year bond yields are negative because the bank of japan has tightened supply and japan is perceived as a safe place to store capital. With the ECB, Switzerland and Nordic countries pursing QE and negative nominal interest rates investors have sought safety within Japanese bonds. This increased demand coupled with restricted supply has driven Japan’s 5 and 10-year bond yields into negative territory.

4. A negative bond yield means that if the bond is held to maturity, the investor gets back less (in nominal terms) than what she paid for it. Why might investors/speculators buy bonds