Negative interest rate

3 key takeaways

• Negative interest rates are used by central banks to stimulate economic activity during periods of low inflation or economic stagnation by making it costly to hold onto cash.
• This policy encourages banks to lend more, businesses to invest, and consumers to spend, thereby boosting economic growth.
• Negative interest rates can have mixed effects, potentially leading to decreased bank profitability, increased risk-taking, and unintended consequences for savers and pension funds.

What is a negative interest rate?

A negative interest rate occurs when central banks set their benchmark interest rates below zero, effectively charging financial institutions for holding excess reserves with the central bank. This policy is designed to encourage banks to lend money rather than hold onto it, thereby increasing liquidity in the economy and stimulating growth.

Key characteristics

• Below-zero rates: Nominal interest rates are set below zero, meaning banks must pay to keep their reserves with the central bank.
• Stimulative intent: The goal is to stimulate borrowing, spending, and investment to counteract economic stagnation or deflationary pressures.
• Unconventional policy: Negative interest rates are considered a non-traditional monetary policy tool, typically used when traditional methods (like lowering interest rates to near zero) have been exhausted.

Importance of negative interest rates

Economic stimulation

Negative interest rates are used to boost economic activity by making borrowing cheaper and saving less attractive, encouraging spending and investment.

Combating deflation

By encouraging spending and investment, negative interest rates can help prevent or counteract deflation, which can lead to reduced consumer spending and economic stagnation.

Financial stability

During times of economic distress, negative interest rates aim to maintain financial stability by ensuring that money continues to flow through the economy rather than being hoarded by banks and individuals.

Key examples of negative interest rates

European Central Bank (ECB)

The ECB introduced negative interest rates in 2014, setting its deposit rate below zero to combat low inflation and stimulate economic growth in the Eurozone. This policy aimed to encourage banks to lend more and boost economic activity across member states.

Bank of Japan (BOJ)

In 2016, the BOJ adopted a negative interest rate policy to address prolonged economic stagnation and deflation. By charging banks for holding excess reserves, the BOJ aimed to promote lending and investment in Japan’s economy.

Swiss National Bank (SNB)

The SNB implemented negative interest rates in 2015 to counteract the appreciation of the Swiss franc and to support economic activity. The policy was designed to make Swiss franc-denominated assets less attractive to foreign investors, thereby stabilizing the currency.

Effects of negative interest rates

Encouraging lending and investment

By making it costly for banks to hold onto excess reserves, negative interest rates encourage banks to lend more to businesses and consumers, promoting investment and spending.

Reducing saving

Negative interest rates make saving less attractive, prompting individuals and businesses to spend or invest their money instead of keeping it in savings accounts.

Lowering borrowing costs

Negative interest rates reduce the cost of borrowing, making it cheaper for businesses to finance projects and for consumers to take out loans, further stimulating economic activity.

Impact on bank profitability

Negative interest rates can squeeze bank profit margins, as banks may struggle to pass on the cost of negative rates to depositors. This can lead to reduced profitability and potential financial instability for banks.

Effects on savers and pension funds

Negative interest rates can erode returns for savers and pension funds, as the yields on safe investments like government bonds fall below zero. This can impact long-term savings and retirement planning.

Benefits of negative interest rates

Stimulating economic growth

By encouraging borrowing, spending, and investment, negative interest rates can help stimulate economic growth during periods of stagnation or recession.

Combating deflation

Negative interest rates can help prevent or counteract deflation by encouraging spending and investment, which boosts demand and stabilizes prices.

Supporting financial stability

During economic downturns, negative interest rates can help maintain financial stability by ensuring that money continues to flow through the economy rather than being hoarded.

Drawbacks of negative interest rates

Bank profitability

Negative interest rates can reduce bank profitability by squeezing net interest margins, potentially leading to reduced lending and financial instability.

Unintended consequences

Negative interest rates can lead to unintended consequences, such as encouraging excessive risk-taking by investors seeking higher returns or negatively impacting savers and pension funds.

Limited effectiveness

There is debate about the long-term effectiveness of negative interest rates, as some studies suggest that the benefits may diminish over time or that the policy may have limited impact on stimulating economic activity.

Example of negative interest rates in practice

ECB’s negative interest rate policy

Since introducing negative interest rates in 2014, the ECB has maintained this policy to stimulate economic growth and combat low inflation. The ECB’s deposit rate was set at -0.5% in 2019. While this policy has helped boost lending and economic activity in the Eurozone, it has also raised concerns about bank profitability and the long-term sustainability of negative rates.

Denmark’s mortgage rates

In Denmark, the implementation of negative interest rates led to an unusual situation where some homeowners received negative mortgage rates, effectively being paid to borrow money. This phenomenon illustrates the unique and sometimes unexpected consequences of negative interest rate policies.

Conclusion

Negative interest rates are an unconventional monetary policy tool used by central banks to stimulate economic activity, combat deflation, and maintain financial stability. By making borrowing cheaper and saving less attractive, negative interest rates encourage lending, investment, and spending. While they offer significant benefits during economic downturns, negative interest rates also pose challenges, including potential impacts on bank profitability, savers, and the effectiveness of the policy over the long term. Understanding the dynamics and implications of negative interest rates is crucial for policymakers, financial institutions, and investors navigating periods of economic uncertainty.

Related Topics:

• Monetary policy
• Inflation and deflation
• Central banking
• Interest rates
• Economic stimulus

Exploring these topics will provide a deeper understanding of the broader context in which negative interest rates are implemented, their impacts on the economy, and the role of central banks in managing economic stability and growth.