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Can interest rates go below zero?

Canada's economic picture is looking sluggish at best lately. The country shed 22,000 jobs in January, after five months of strong gains. Worse, economic growth in the US, our largest trading partner, was actually negative during the fourth quarter of 2012. As if that weren't enough, a new International Monetary Fund report says Canadian economic risks remain weighed to the downside.

Sluggish recovery a mystery
This continuing sluggishness on both sides of the border, five years after the US financial sector collapse and ensuing downturn, is something of a mystery. A recovery from a recession of that scale would typically be far stronger, particularly in light on the massive fiscal and economic stimulus that governments have pumped into the economy.

Part of the challenge, is that much of the economic growth that occurred in the Western world during the two decades prior to the economic troubles, was fueled by central banks printing money.

The Bank of Canada's policy of cutting interest rates at almost every sign of sluggishness is a perfect example. To be fair, other central banks, including the US Federal Reserve, the European Central Bank and the Bank of England have all been doing the same thing.

However with policy interest rates now near zero pretty much everywhere (0.75 per cent in Canada), politicians and economists are running out of room to do much more. After all, you can't cut interest rates below zero can you?

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Real interest rates
Well, actually you can. In fact Canada's central bank is doing this right now, by playing with real interest rates (interest rates less inflation). Using "sleight of hand" they make it look like you are earning money on your savings, when you are actually losing.

Here is how it works. Let's say you buy a 90-day Treasury Bill that pays an annual rate of 1 per cent, but inflation comes in at 0.8 per cent (as it did in December). That means your interest gains are almost totally wiped out (1 per cent less 0.8 per cent, leaves you with 0.2 per cent in interest, near zero).

Now let's say core inflation hits the Bank of Canada's 2.0 per cent mid-point target. If that happens, those who buy bonds will actually lose money (1 per cent of interest, less 2.0 per cent inflation). It gets worse, because our example does not include the taxes that many Canadians pay on their interest income.

Financial repression
Economists call the negative interest rate policies run by governments "financial repression," because they penalize savers who manage their money well and they bail out borrowers and spenders.

That said, there are signs that financial repression is going to become increasingly widespread in the coming years. Money printing and low interest rates are like a "sugar high" for athletes: They boost temporary performance, but they don't build the muscle and skills that are needed to compete over the long-term. Worse, not only are sugar highs hard to stop, it takes more and more sugar to keep getting the same high.

The good news is that Canadians are luckier than most. The country has vast natural resources, such as the Alberta tar sands, gold mines throughout Quebec and Ontario and potash in Saskatchewan, which are wanted the world over. These will go along way towards alleviating the pain that many other countries will feel when the effect of the sugar high starts to wear off.

Peter Diekmeyer is Bankrate.ca's economics writer. He can be reached at peter@peterdiekmeyer.com.

-- Posted February 21, 2013
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