The economic slump which followed the 2008 financial crisis pushed central banks to resort to unconventional monetary measures to boost inflation and reinvigorate the economy. In Europe and Japan, the central banks experimented with negative interest rate policies, to counter chronically low inflation and weak economic growth. The effectiveness of negative interest policies has become the subject of much debate.
The rationale behind negative interest rates
During periods of falling prices or deflation, businesses and households postpone their spending or investing activities, resulting in declining aggregate demand, further price declines, a slowdown in production and output, and an increase in unemployment.
Loose monetary policies in the form of lower interest rates are employed to address such economic stagnation. Advocates of negative interest rate policies believe that cutting interest rates to zero is not sufficient to counter persistent deflationary pressures.
A brief history of negative interest rates
During the 1970s, Switzerland placed a surcharge on non-resident deposits, resulting in a de-facto negative interest rates, to counter the strengthening of the Swiss Franc. It later abandoned it in favor of direct currency targeting.
The 2008 financial crisis resulted in an economic slump. In the aftermath, Sweden and later Denmark used negative interest rates to stem hot money flows into their economies. In 2014, the European Central Bank (ECB) instituted negative interest rates that applied only to bank deposits with the central bank, in order to prevent the Eurozone falling into a deflationary cycle.
The Bank of Japan adopted negative interest rates in the beginning of 2016, mostly in order to prevent the yen from strengthening and hurting the export-driven economy. In 2019, the ECB cut its benchmark rates even further into the red.
Penalizing non-productive cash holdings
Under a negative interest rate policy, banks are are charged interest for parking their excess funds with the central bank. Effectively, the central banks are penalizing financial institutions for holding on to cash, and prompting them to increase lending to businesses and consumers.
There is a limit to how far central banks can push rates into negative territory. Depositors will avoid being charged interest by choosing to hold cash instead.
Foreign exchange rates
In addition to lowering funding rates, negative interest rate are intended to weaken a country’s currency in relation to other currencies. A weaker currency will make a country’s exports more competitive, and serve to increase inflation by pushing up import costs.
The transmission mechanism
Negative central bank rates lower the borrowing cost on a range of other financial instruments, which means means businesses and households benefit from cheaper loans.
Institutions and households who deposit funds with the banks, will seek alternative financial assets, such as bonds, in which to invest. This, in turn, increases the demand for such assets, which increases the price and lowers the interest rate earned on those assets.
In order to compete in capital markets, the banks would need to reduce the interest they charge on loans too. In this manner, the lower interest rates are transmitted through financial markets.
Effect on bank margins
Negative interest rate narrow the margins that financial institutions earn from lending. In order to maintain their margins when negative interest rates apply, the banks would need to lower the interest they pay to institutions and households or pass on the cost by increasing fees.
Retail banks may choose not to pass on the cost associated with negative interest rates to their deposits, else depositors may choose to move their holdings into cash. This is borne out by the declining bank margins of the European banks.
If negative interest rates are maintained for a prolonged period of time, it will hurt financial institutions and inhibit their ability to expand their financing and investment activities. Moreover, financial institutions will be inclined to take on more risk, rather than be stuck with costly deposits, and in so doing increase the risk of failure.
In order to mitigate the pressure negative rates place on bank margins, central banks have adopted a tiered system under which negative interest applies only to a portion of the excess reserves financial institutions deposit with the central bank. A zero or low interest rate is applied to the rest of the reserves. Alternatively, a set amount of reserves is exempted from negative rates. But excess liquidity is concentrated in the larger banks in wealthy countries, resulting in a tiered system not benefiting all banks equally.
Savers and pensioners
In countries with ageing populations, negative interest rate policies may not have the desired effect. Savers and retired people who live off their pensions and interest income, would be more likely to reduce their spending when faced with lower interest rates.
The increased purchasing power of borrowers due to negative interest rates is thought to make up for the lower propensity to spend by pensioners and savers. However, the compounding effect of negative treasury yields over an extended period of time threatens the stability, and indeed viability, of pension and insurance funds.
Unintended consequences
Maintained negative interest rates distort capital allocation and encourage unmanageable levels of debt and risk-taking behavior, potentially leading to another financial crisis. The long term effect of negative interest rates on the ability of financial institution to fund economic growth, and on the viability of pension and insurance funds, may have unintended socio-political consequences in the future.
Further reading:
The impact of negative interest rates on banks and firms
Pension funds need to make the case against negative interest rates
The case against negative interest rates
Photo credit: DXR [CC BY-SA 4.0 ()]