NIRP: A Disease of the Twenty-first Century

Central banks (CB) of the world have begun experimenting with a range of monetary policies never tried before. Although they have a certain academic or theoretical underpinning, they are being implemented without any significant experience to assess their effectiveness.

The latest one to emerge from the labs of the CBs is Negative Interest Rate Policy or NIRP. We will first provide enough background that anyone can make sense of these policies. More importantly, in the case of NIRP, we will show how it will be an economic and social disaster for the person on the street. We will also reveal who stands to gain from the economic destruction that NIRP will create. First, however, we discuss positive interest rates.

1. Anatomy of Interest Rates and the Credit Market

Loans comprise the largest segment of financial activity in the economy. Loans are debt instruments that take many forms such as those found in the bond market including Canada Savings Bonds. Other categories of loans include commercial lending to business, and the variety of loans and credit in the personal financial sector such as student loans, auto loans, mortgages, lines of credit, and outstanding credit card balances. The aggregate of all loans is termed the total credit market debt outstanding (TCMDO) of a country. Figure 1 shows the TCMDO for the U.S.

The credit market is comprised of all the lenders involved. Normally we associate the chartered banks and credit unions as the lenders. But there are numerous small investment banks and financial services firms that lend to business as well as private individuals. Technically, the loan you give to your brother-in-law is part of the credit market debt and you are part of the credit market although the loan will never be officially measured.

Figure 1. TCMDO in the U.S., 1952 to date (red line) and the leverage of the debt market (total debt / currency in circulation) (blue line). Recessions are shown as vertical white bars.

Source: FRED®

Although U.S. debt continues to grow, the money supply as currency in circulation has grown even faster, reducing the leverage in the credit market from a high of 65.5 in 2008 to 45.4 in the third quarter (Q3) of 2015. Leverage means that as of this writing,  for every dollar of currency in circulation there are 45.5 dollars of loans against it. The risk of high leverage is that if an event occurred in financial markets that forced a large number of loans to be recalled, there would not be enough dollars available to do so creating loan defaults on a possibly large scale.

When money is loaned by a lender or creditor to a borrower or debtorinterest is usually charged on the loan. Three major considerations that go into determining the actual interest rate are:

  1. The return on the lenders money. This is the amount of money he/she (hereafter just ‘he’) would expect to be paid over the term of the loan to compensate him for the use of his money. Think of it as rent on the principal amount of the loan.
  2. A risk or default premium: the lender assesses how creditworthy the borrower is and adds a component as an insurance premium against the borrower not repaying the loan in part of in full.
  3. An inflation hedge: normally there is some amount of inflation in the economy (see Figure2). Inflation means that the price of an asset or object at some time in the future will cost more in dollar terms than the price of the same object today. This is a way of saying that when the loan comes due and is repaid, the money the lender receives has lost purchasing power or value by the amount of inflation.

The lender considers these three factors and comes up with a rate of interest that he would like to be paid for the loan. The credit market is very large, much larger than the stock market, so the lender also has to consider what the competition is charging. You can see this when you go to the five major banks and price out an auto loan. There will likely not be much difference, depending in part on how badly a bank wants to lend out idle money. Often, the borrower may have a small room for negotiation.

Until recently a negative rate of interest implying the lender will pay interest to the borrower, was unheard of. More on this shortly.

2. The Business Cycle and the Economy

Like many natural complex systems such as animal populations and sea temperatures, economies exhibit cyclical behavior called the business cycle. One description of it is in terms of consumer psychology. Consumer activity constitutes the largest segment of economic activity in North America at two thirds or more. When people feel good about their financial position and the state of the economy – they have an apparently secure job, no foreseeable problems, and a reasonable debt load – they tend to borrow to spend. They buy something that they had been holding back on or make a major purchase such as a car, a house, or a cottage.

Consumer spending in turn causes businesses to spend. They may feel it’s time to build a new factory or update equipment, and borrow accordingly. This capital expenditure or CAPEX is the second of three major segments of the economy. Business expansion not only consists of CAPEX but of new jobs, decreasing unemployment. Both segments increase economic activity in a feedback loop measured as economic growth.

The third segment which we will not discuss as it does not add to economic growth is government spending.

As borrowing increases and stimulates the economy through spending, borrowers reach the limit of their credit capacity. Loan repayments consume so much of their income that they have to reduce further spending. Consumption slows and spare capacity appears in the economy driving down wages, industrial production, service utilization and prices. Market psychology shifts to apprehension. Jobs are lost and bankruptcies increase in a feedback loop on the downside. These economic contractions we label as recessions.  Eventually excess in the system is purged, the weak are weeded out as with animal populations, and growth begins again.

Can we avoid these natural cycles? No, but we try, and therein lies the problem.

3. Enter the Central Bank

A key aspect of economic expansion is the borrowing necessary to support increased personal consumption and business CAPEX. In an expanding economy the demand for loans increases. At the same time shortages begin to appear and excess capacity is removed from the system causing prices to rise, known as inflation.

In a contracting economy in which economic growth is decreasing, the demand for loans decreases.  At the same time surpluses begin to appear along with excess capacity in businesses. Prices including wages start to decline causing deflation.

Since a primary mandate of most central banks is to maintain price stability and economic growth, historically they have used interest rates to modify growth. CBs found that by raising rates in an over-heated economy they could discourage additional borrowing both in consumers and in business, thus dampening growth. They could do the reverse in a contracting economy by lowering interest rates to encourage consumers and businesses that may have been restraining spending, to borrow and spend.

Until now we have talked about how market forces determine or “discover” appropriate interest rates. Central banks, however, have a unique ability to influence short-term interest rates. The tool that they use is something called the fed(eral) funds rate (in the U.S.) and is the rate of interest that the CB charges its member banks for overnight borrowing, a requirement that occurs frequently due to the small amount of cash banks actually have on hand at any time.

This is lowest rate at which banks can borrow money (except for deposits) and they use this rate to set the rates that they will charge their customers. Appendix 1 shows the effect of the U.S. Federal Reserve’s (Fed) intervention in the market and the impact it has had on economic growth in the U.S. Figure 3 shows that the use of this interest rate tool became increasingly ineffective from the early 1980s on.

As discussed in Appendix 1, this interest rate tool broke in December, 2008[5] when the fed funds rate reached 0.1%, considered to be the zero lower bound with associated policy (ZIRP).

At this point, the Fed resorted to a new tool in various forms referred to as quantitative easing (QE). These efforts[5], QE1, December 2008 to March 2010, QE2, November 2010 to June 2011, Operation Twist, 2011, and QE3, September 2012 to December 2013, shown in Figure 4, only succeeded in producing the weakest economic recovery in U.S. history described in Appendix 2.

What is more, we have no idea what a recovery would have looked like if the Fed had not intervened with QE. Claims that things would have been worse are obviously unsubstantiatable. Nor, because of the existence of the business cycle, can we definitively attribute success to any Fed intervention after ZIRP.

With the global economy approaching recession in 2016 and several countries in recession in 2015, desperate central banks began to experiment with a new untested interest rate tool: negative interest rates, the topic of the next section.

4. NIRP: Negative Interest Rate Policy

In Section 1 we gave a simplistic 3-point list of considerations for setting rates. The first, what the lender wants to earn in real or inflation adjusted terms is not likely to change much over time. The second point regarding risk should not change if the lender did a good risk analysis before making the loan. The third, inflation, is the wild card. Figure 2 shows the measure of inflation called the consumer price index (CPI). When the index is rising it means there is price inflation in the economy. When it is falling, deflation is occurring.

In over a hundred years of data, there have been only two major downturns. The shorter was 5 months in 2008 during the Great Recession. The longer was in the Great Depression era. The CPI peaked in June 1920 and fell for 13 years into March-May, 1933 when it started rising and surpassed the 1920 peak in November 1946.

Recall that a rational market participant in his calculation of an interest rate includes an amount which is his estimate of the loss of value of his money due to inflation. But what about deflation? If there is a net deflation over the life of the loan, the principal that the lender gets back has more value (buying power) than at the time of the loan because prices have fallen.

Such a lender might decide that he could reduce the interest rate by the amount of deflation creating a lower lending rate while giving him the same value return as in an inflationary rate calculation. But with less than 15% of the hundred years in deflation, a rational investor would not likely make this bet. There would never be negative interest rates in a free market.

Figure 2. The consumer price index in the U.S.

Source: FRED®

CBs, however are not rational market participants in the sense that they want to make money. Having reduced their lending rates to member banks to zero in trying to induce economic activity, some CBs think that they can stimulate economic activity by taking interest rates negative.

5. What Were They Thinking?


6. Summary

The absolutely wicked thing about central banks is their one-sided understanding of the economy. They have only regard for the collective result of the actions of the millions of individuals and enterprises that are the economy. Their single objective in downturns is to increase consumer spending to stimulate economic activity. That debt levels are at historical highs is not a concern that they ever voice. That participants in the economy may not have room to take on further debt has never been voiced as a problem.

This process has constituted a great war against savers. People dependent on interest income on their life’s savings have watched it dwindle to nothing. Pension plans that were constructed in the better economic climate of the mid-twentieth century when an 8% return on invested contributions was relatively low risk, now have trouble making 4% without elevated risk in other asset classes. As a result, pension plans across the country are underfunded and cities are going bankrupt trying to meet their obligations.

Make money essentially free with zero interest rates – well that didn’t do much for the economy. Here’s an idea. Let’s make interest rates negative forcing savers to take their money out of banks and spend it … oops. What if they don’t spend it but literally stick it under their mattress creating a liquidity crisis in the economy. Well they have a plan for that also which will be the second part of our series on the destruction of your wealth. As a hint, they will outlaw currency, leaving only bank deposits. Wait till we show you what that will do to you and the economy.


The central banks have destroyed the lives of many of the elderly and their practices are destroying the retirement of generations to come.

Appendix 1: Fed Interest Rate Intervention in the Economy

Perhaps the most widely used measure of economic activity is the gross domestic product or GDP. In Appendix 2 we show an inflation adjusted GDP or output, along with change in employment. For GDP, Figure 3 shows the relationship between changes in GDP and changes in the fed funds rate.

Figure 3. Year over year percent change in GDP (blue) versus the Fed Funds Rate (red). Recessions appear as vertical white bars.

Source: FRED®

Figure 4. Figure 3 with trend lines added for GDP (light blue) and the fed funds rate (yellow) (click to enlarge in a new window). The period of QE is delineated by the black vertical lines.

Source: FRED®

The start and end dates of recessions in the U.S. are officially determined by the National Bureau of Economic Research (NBER). It usually takes months after a recession starts before it is officially determined. Therefore the Fed has to act on its own data. Recall that we explained that the Fed adjusts interest rates to alter the overall activity of the economy.

We have added trend lines to Figure 3 in Figure 4. The two light blue lines bound the GDP data.  The lower horizontal blue line shows that the depth of the worst recessions measured as negative GDP, is about -2.5. The upper blue line is more interesting. With the exception of the recessions of the 1980s, it bounds the maximum GDP growth in a business cycle.

Two things can be observed from this. The first is that with each successive business cycle, the maximum GDP growth has been decreasing while the negative contractions have a roughly fixed limit. The trend, however is disturbing because the upper blue line which is the limit on economic expansion, intersects the zero line in about 10 years. At this point the economy will always be in contraction.

The second point to observe is that the time between recessions in the 1950s has lengthened more recently, another indication that the Fed’s interest rate intervention (red curve), is evening out the business cycle.

The next point to observe is the relationship between peaks and troughs in the cycles of the two curves. For the recessions of 1990 and 2001, the economy had bottomed and began turning upwards about 2 years before the Fed started raising rates again. In both cases, the Fed started raising rates in the next business cycle when economic growth was either near or past its peak for the cycle. Arguably, the Fed should not have been raising rates but maintaining them at a steady state.

The final comment is about the FFR which reached the zero bound at 0.16 in Dec. 2008 (Figure 2). If the FFR had followed the pattern of the previous two recessions it would have gone negative and spent a few months making a bottom before turning back up sometime near April 2011. By then, however, the economy had recovered to its maximum level in the current business cycle. Raising rates from the hypothetical negative level would have sent the economy back towards recession, possibly before rates could have been restored to zero.

Given the relatively weak recovery from the last recession at an average of about 2.5%, there was no call for the fed to raise rates. In fact, could they lower rates further, that might have been the strategy to follow. The fed did raise the FFR by 0.25% in December 2015, but it is hotly debated as to whether they can raise it further. The yellow trend line in Figure 3 suggests that 3% is about all they may be able to achieve. However, they are probably too late in the cycle to get anywhere near that level before the next recession at which point they will have to start lowering rates again. This time, however the zero bound is not far away. The tool is broken and can’t be fixed.

Appendix 2: The Weakest U.S. Recovery on Record

This recovery has recently been described as the “worst economic recovery ever”[1][4], and the “worst since WWII”[2][3]. There are many other similar characterizations that are older given that the recovery is so protracted. Figures 5 and 6 show data that supports the argument that the latest recovery is the weakest since World War II. This recovery has been described variously as the worst economic recovery ever[1][4], and the worst since WWII[2][3].

Figure 5. The increase in the output (inflation adjusted GDP) of the economy from the 2007 recession is the weakest since WW II (click to enlarge in a new window).

Source: The Federal Reserve Bank of Minneapolis.

Figure 6. The percent change in employment from the 2007 recession is the second weakest since WW II (click to enlarge in a new window).

Source: The Federal Reserve Bank of Minneapolis.

This recovery has seen

Appendix 3: A History of Inflation in the U.S.



6. References

1. Investor Business Daily: Sorry, This Is Still The Worst Economic Recovery Ever, Dec. 31, 2015.
2. Bloomberg: This Recovery Really Is Different, Aug 6, 2015.
3. The Wall Street Journal: The Worst Expansion Since World War II Was Even Weaker, July 30. 2015.
4. Center for Individual Freedom: Obama “Recovery” Objectively Worst on Record, Aug. 6, 2015.
5. Wikipedia: History of Federal Open Market Committee actions.
6. Washington Post: He Told Us to Go Shopping. Now the Bill Is Due, Oct. 5, 2008.


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