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Comprehending Negative Interest Rates: Central Banks' Red Bull for Economies

Sep 7, 2020 10:32 AM 4 min read
Editorial

The ongoing pandemic has severely hit businesses across the globe, and there has been a lot of talk around economies entering a recession phase or having already entered one. In order to tackle this severe decline in activity, central banks of some of the leading economies, including Bank of England, are now mulling cutting interest rates to below zero.

Negative interest rates? Does it mean you have to pay the bank for keeping your money and the bank would pay you for borrowing money?!

But before we get into the mechanics of negative interest rate, let’s first try to understand how the basic economic cycle works.

The Working of An Economic Cycle

A central bank’s primary job is to control interest rates and inflation.

When the economy is doing well and interest rates are low, people tend to spend more. Their spending is driven by access to cheap credit provided by banks in the form of home loans, car loans, or credit cards. This, in turn, increases employment, economic prosperity, and overall materialistic quality of life.

However, over time, due to the availability of cheap credit and limited supply of goods and services, prices of these goods and services tend to rise, which is known as “inflation”.

As central banks analyse people’s spending pattern and rising levels of inflation, they increase the interest rates which eventually reduces borrowing. Reduced borrowing and high interest rates on loans result in lower spending, over time leading to deflation.

And thus, the economic cycle continues.

 

Comprehending Negative Interest Rates: Central Banks' Red Bull for Economies

 

The Proof is in The Pudding

Since the 2008 financial crisis and eurozone crisis, governments and central banks have struggled to boost the sluggish economy. People have become more cautious about the way they are spending and banks have become restrictive on lending. So to stir up the sluggish economy, central banks kept on lowering the interest rates eventually entering the negative territory for the first time in 2009.

In 2009, Swedish Central Bank turned the overnight deposit rate to -0.25%, which meant that the commercial banks had to pay for depositing the money in the central bank. This was done to encourage banks to lend more instead of depositing the money with them.

Just FYI: Even though deposit rates were negative, interest rates on borrowing and on saving accounts were still positive.

This policy was later implemented in the eurozone in 2014 by the European Central Bank (ECB) followed by the Bank of Japan in 2016.

Advocates of the negative rate policy claim that besides cheap credit, it also helps to combat deflation in an economy. Take for example Country A, whose central bank cuts interest rates to the negative territory. The government expects that cheap credit would encourage people to spend and invest more.  Country A’s currency is devalued as investors find more attractive destinations to park their money. Due to the currency’s devaluation, its exchange rate weakens which helps to encourage exports and discourage imports. This creates a greater demand for domestic goods in Country A. Asset prices increase and help businesses to grow, thus boosting the economy, giving way for inflation.

Negative Rates - A Boon Or A Curse?

Though its main idea was to boost investing, lending and spending, the countries that have implemented negative interest rates have struggled with slow growth and deflation. It has also squeezed profit margins for the banks since they have to pay for the deposits they receive. Pension funds and low-risk investors have been hit severely as they are being forced to invest in riskier positions rather than safer bonds and bank deposits.

As Huw van Steenis, senior adviser to UBS and former Bank of England advisor says,

Negative rates are a bit like steroids. They are great in a short, sharp usage but long-term usage of steroids starts to dissolve your bones.

There is also a risk of asset bubbles being created if interest rates turn negative on mortgages as it would drive prices to unsustainable levels. This happened in Denmark where a Danish Bank was offering -0.5% on mortgages.

The central bank of countries like Switzerland, Japan, and Germany are still adamant to move forward with negative rates though the past results haven't been very impressive. The reason for adopting sub-zero interest rates has been to promote lending and investment activity. In the case of Switzerland, this policy was instituted to curb the appreciation of its currency. While the results of this policy have been mixed so far, it has been instrumental in making these countries “safe havens” for investors. Thus, they are unlikely to change from negative rates in the near future. Recently, US President Donald Trump tweeted "As long as other countries are receiving the benefits of negative rates the USA should also accept the 'GIFT'. Big numbers!".

Negative interest rates were an abstract concept 15 years ago and its ramifications are still not very clear. All we can do is speculate about its future.

 

Written by Akshat

FIN.

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