Negative interest rates, a largely unknown and rarely used financial tool, are increasingly being considered by central banks around the world. What is this concept and how does it work?
For many nations, their economic and financial well-being has not improved since the financial crisis of 2008-2009. Central banks around the world have tried the traditional methods of lowering interest rates and putting more money into circulation through bond purchases. However, with interest rates at or near zero percent and the economies of nations such as Japan on the downside, the stimulus options for central banks are few. Drastic times call for drastic measures and the use of negative interest rates, a rarely used and largely unknown financial concept, may be the only avenue available to help economies move forward. But the big question is: will it work?
What are negative interest rates?
The concept of negative interest rates runs counter-intuitive to what has generally been regarded as not only conventional methodology to stimulate an economy, but also to what the average person believes about the relationship between a bank and its customer. In a normal banking relationship, a client deposits money with a bank in a savings account or certificate of deposit and expects to receive interest perhaps quarterly or semi-annually.
However, with negative interest rates, the saver will have their deposit returned minus a percentage that the bank will keep. The premise is that the bank will extract a fee, possibly on a percentage basis, for holding the saver’s funds, acting as a type of storage fee. This also applies to commercial or savings banks that deposit their savings with the central banks. By charging a fee, central banks are trying to incentivize banks to make loans in order to stimulate the economy rather than hoarding cash and earning interest.
A key reason for negative interest rates is that central banks around the world are running out of options to stimulate their respective economies. Normally, a central bank will lower interest rates in order to make loans cheaper and incentivize businesses to borrow. However, interest rates are today often at or near zero percent and global economies are still stagnant or face possible recessions in the near future. Many central banks are desperate for ways to stimulate their economies and believe that negative interest rates are the only avenue left open to them.
And it is not only central banks using this tactic, but also governments. At the end of April 2016, approximately $8 trillion of government bonds globally had yields below zero percent. For those investors holding these government bonds until maturity, they will not receive all of their original investment.
On top this, economic stimulus is designed to have some degree of inflation, but for a number of years now there has been deflation. Policymakers and central bankers hope that negative interest rates will stimulate diverse economies so that there will be some inflation which means economic growth. Deflation has resulted in economic contraction and traditional monetary and fiscal policies are not working to move economies forward.
Among the nations where negative interest rates have been implemented are Sweden, Switzerland, Denmark, Japan through the Bank of Japan (BoJ), and the Eurozone through the European Central Bank (ECB). The ECB adjusted their interest rates in March and is charging member banks 0.4 percent on their overnight deposits while the Swiss National Bank has a rate of minus 0.75 percent. In January of this year the Board of the BoJ, in a narrow 5 to 4 vote, set interest rates of minus 0.1 percent for excess reserves its holds for member banks.
These nations are hoping to prevent another recession but also weaken their respective currencies so as to increase demand for their nation’s goods and services in order to stimulate their economies.
Possible implications
Negative interest rates could have significant financial implications in the long and short term. For the major economies, there are no past experiences to draw from in using negative rates. It may help their currencies go down but how soon and for how long is another key question.
A key financial implication of negative rates is that savers will get hurt in the long and short run. They will be dissuaded from putting money away for retirement and might actually start to put their funds under their mattress, They will hope for deflation since inflation will eat away at the value of their money and they could end up poorer in the long run.
Negative rates may also cause housing bubbles globally since savers would find it advantageous to buy a home in the hope that it will increase in value over time. Also, taking a mortgage on their home would make financial sense since lenders would have to pay borrowers for use of the principal. This has already occurred in Denmark.
What are the results?
The big question is whether negative interest rates will actually work or not. Janet Yellen, Federal Reserve Bank Chair, is keeping an eye on the actions of the ECB and BoJ and has stated publicly the possibility of negative rates being implemented in the United States in the future. She is concerned about the lackluster growth of the U.S. economy and with rates very low, she would be open to alternatives – if they work as intended.
