How Positive are Negative Interest Rates?
Updated: Jul 9, 2020
Harneet Singh
St. Xavier's College, Mumbai
Negative interest rate policy, as astonishing as it sounds, has actually been in the monetary economics scene for more than a decade. People have tried to de-code this unconventional monetary policy tool for years, and still have arrived at different definitions and perceptions about it. This article is aimed at clearing our concepts and busting myths about the negative interest rates that have plagued our mind since we heard this word for the first time.
What is it and why does it exist?
Negative Interest Rate policy (NIRP) is said to exist when the central bank of any country, sets its policy rate in the negative territory, usually the deposit facility rate (rate at which banks park their excess cash with the central bank) or the repo rate (rate at which the banks borrow money from the central bank). It means that banks need to pay the central bank a penalty or interest to park their excess funds with them, or get money in turn of borrowing money from the central bank. It does not mean that the retail borrowers like you and me get loans for free and instead we get paid. Whereas that would have be a really lucky situation for us, lending rates cannot really be negative as banks require a positive profit margin over the deposit interest rates to manage their operating expenses. The ultimate benefit for borrowers is that the lending rate significantly comes down, and the profit margin that banks earn is significantly lesser than before.
The reasons for why this has been carried out can be traced to the probably the greatest case study for the students of economics – the Great Financial Crisis of 2008. During the years of 2008-09, when the world was facing a terrible slowdown and economies were in recession, central banks across the world lowered their rates of interest to boost investment and consumption and give inflation a push. Even after the crisis had passed, countries continued to see a sluggish growth, and meagre increases in consumption and price level. This can clearly be concluded by what we generally study as the Liquidity Preference Theory of JM Keynes. Below a certain level, any further decreases in the interest rate does not impact the investment capacity of people as they have complete liquidity preference (they hoard cash instead of investing it). More commonly known as the liquidity trap, this is the situation which a lot of countries faced a decade ago. Hence when they realised that there is no space to decrease the interest rates further, they dropped it into the negative territory, in a hope that it will boost inflation and would strengthen the economic growth.
Which countries have implemented this policy?
This unconventional monetary policy has been implemented by the strongest nations and central banks of the world. The first country to adopt a version of this policy was Sweden, in 2009 when it cut its overnight deposit facility rate below zero. Following this avant-garde, the European Central Bank set its deposit rate at -0.1% in June 2014, which is as of now at -0.5%. Even Danish Central Bank in 2012 and Bank of Japan in 2016 adopted negative deposit facility rates. Out of them, Sweden is the only one who has adopted a negative repo rate, while the repo rate for others is still in a positive territory (although its nearly 0% for all).
Is it useful or is it problematic?
Up until the December of 2019, the supporters of this policy had a lot to say in favour of it. What changed post December was the fact that Sweden, the first country to adopt NIRP raised its interest rates by 25 bps (0.25%), and its repo rate is now set at a 0%. While the Riksbank, the Swedish central bank said this was carried out because the inflation had met its target, the real reason that was covered in the December meeting of the central bank. According to the minutes of the meeting, the bank has accepted the pros and cons of the NIRP and has concluded that the cons outweigh the pros, and has decided to terminate this policy. Let’s see how the NIRP impacts the economy.
Well covering the positives first, the two main areas where the NIRP boosts the economy is in the terms of the inflation rate and exports.
Inflation Rate – As it’s proved in economic theory, a decrease in the interest rates, inversely impacts the inflation rate in any economy. When the interest rates jump in the negative territory, credit is expected to boost. Since borrowings would increase, consumption and investment would also increase, pushing the aggregate demand in the economy. Hence, it stimulates the economy and positively impacts the economic growth. In Sweden, the CPI growth rate in 2014 (before the repo rate went negative) was around -0.31% which has improved to above 2% inflation rate in 2019. Similarly, in the Euro-Area, inflation has remained in the positive territory after the implementation of NIRP. When we observe the figure above, the line represents the exact year that Sweden turned its repo rate negative. Post 2014, the growth in inflation rate has almost been linear and quite significant.
Exports – When the interest rates go down, it makes the country an unfavourable destination for investment, hence leading to repatriation of foreign investments and increase in the domestic investors making investments abroad. This in turn leads to depreciation of the currency (as people demand more of foreign currency). Greater depreciation implies higher demand for exports. This is very beneficial in cases of highly export reliant economies like Japan and some of the Euro-Area countries.
Now coming to the negatives of the negative interest rates, economists have strongly argued that it weakens the economic system of the entire country. One of the most prominent disadvantages of NIRP is the deep hit that the financial sector is on the receiving end of. Being sandwiched between a gun on their head by the central bank who wants them to lend more, and no option of reducing deposit rates lest they face a liquidity crunch, banks have to decrease the lending rate and hence their profitability margins.
Not only the banks, but also other financial institutions like the pension and the insurance market also incur high risks as they invest primarily in bond markets. In Sweden, the pension dues in 2019 were paid down to the wire, as a negative yield persists in the bond market due to a negative interest rate.
Another major disadvantage of the negative interest rate policy is the high preference to liquidity in that situation. If not implemented carefully, the economy can land itself into a liquidity trap as people would choose not to invest their money and would rather hold them in a cash form. This liquidity preference ends up being a major leakage from the economy and can lead to a potential deflationary spiral, where the monetary policy becomes ineffective. A Princeton University professor, Markus Brunnermeier had proposed the idea of a reversal interest rate, which hypothesized that there is a certain negative interest rate level, beyond which if the interest rate is decreased, can lead to contractionary conditions in the economy instead of boosting it.
Conclusion
Negative Interest Rate Policy might be a short-term solution, but it lands the economy back to square one if implemented for a longer period. Proper structural changes and fiscal mechanisms that enhance its applicability, is the only way that negative interest rates can actually turn out to be helpful for the economy. To avoid a liquidity trap situation, there needs to be a fair balance between monetary policies and fiscal stimuli, both of which are imperative for effective economic growth.
References
Alsterlind, J. (2015). How far can the repo rate be cut? Economic Commentary, Riksbank.
Brunnermeier, M., & Koby, Y. (2019). The Reversal Interest Rate: The Effective Lower Bound on Monetary Policy. Princeton University.
Eisenschmidt, J., & Smets, F. (2019). Negative Interest Rates: Lessons from the Euro Area.
Explainer: How does negative interest rates policy work? (2019, September 13). Retrieved from Reuters: https://in.reuters.com/article/ecb-policy-rates/explainer-how-does-negative-interest-rates-policy-work-idINKCN1VY1VO
Jobst, A., & Lin, H. (2016). Negative Interest Rate Policy (NIRP): Implications for Monetary Transmission and Bank Profitability in Euro-Area. International Monetary Fund.
Khayat, A. (2015). Negative Policy Rates, Banking Flows and Exchange Rates. AMSE Working Papers .
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Singh, H. (2020). Assessing the Positivity of Negative Interests Rates with reference to the Euro-Area. Arthniti ISSN 2277-1344. Retrieved from http://xaviers.edu.in/ojs3/index.php/arthniti/article/view/138/101
Sweden Says Enough Is Enough on Negative Rates. (2019). Retrieved from Bloomberg: https://www.bloomberg.com/opinion/articles/2019-12-19/sweden-s-riksbank-has-had-enough-of-negative-interest-rates