What Happens if Nominal Interest Rates Go To Zero?

In the article What Happens if Interest Rates Go To Zero? we saw a way that real interest rates could be negative:

Suppose the interest rate on a bond in Norway is 4%, but inflation in that country is 6%. That sounds like a bad deal for a Norwegian investor because by buying the bond their future real purchasing power would decline. However, if I'm an American investor and I think the Norwegian krone is going to increase 10% over the U.S. dollar, then buying these bonds is a good deal. If I'm right about the currency jump, then I'll gain 10% from switching from the U.S. dollar to Norwegian krone denominated bonds today. On top of that, I'll also receive the 4% gain in interest.

The History of Negative Real Interest Rates

This appears to have only happened all of once in monetary history - during the late 1970s in Switzerland. I had a number of readers ask me why this doesn't happen more often - it seems like something that should happen a fair deal. The reason is as follows: If investors believe that a currency or a stock is going to jump up 10% in the future, they will want to purchase that asset as soon as possible. By doing so, they increase the demand for that asset, which increases the price. Eventually the price gets pushed up until that 10% jump is realized right away. These types of self-fufilling prophecies are common in economics - if we expect that an asset will go up in value in the future, investors buy up the asset, and voila, the asset goes up in value today.

That's why typically we do not see situations like our hypothetical example. If investors believed that the Norwegian krone would be worth more in the future, they would buy more today, pushing up the value of the krone. Then the current value of the krone is roughly identical to the expected future value and the opportunity to make money from a bond with a negative real interest rate goes away.

If a large gap between current value and expected future value is to persist, it must because there is something preventing people from buying large amounts of a currency on foreign exchange markets. Perhaps it's due to a law preventing selling "large" amounts of a country's currency to "foreigners". Perhaps it is due to high transaction costs or a tax on large foreign exchange transactions.

But What About Negative Nominal Interest Rates?

What does any of this have to do with negative nominal interest rates? Well, if a situation like the above occured where there were structural reasons why the gap between the current value of a currency and the expected future value could not be closed, then a negative nominal interest rate could be attractive to investors. Typically speaking no one would buy an asset that stated "If you give me 100 Norwegian krone today, I'll give you 95 Norwegian krone next year." But if we expected that the Norwegian krone was going to shoot up in value, then a bond that stated "If you give me the U.S. Dollar equivalent of 100 Norwegian krone on Jan 1, 2006 (at Jan 1, 2006 exchange rates), I'll give you the U.S. Dollar equivalent of 95 Norwegian krone on Jan 1, 2007 (at Jan 1, 2007 exchange rates)" may be a profitable investment.

Other than that statisical oddity, I cannot forsee a situation where nominal interest rates would ever be negative. Even in Japan with a fairly serious deflation, the nominal interest rates on 3-month government bonds were typically some very small positive amount such as 0.02 or 0.03.

I hope this answers your question about negative real interest rates. If you have a question about interest rates, please contact us, by using the feedback form.