Understanding Negative Interest Rates

Interest rates are typically defined as the cost of borrowing money

At first glance, negative interest rates may seem like an illogical, if not outright insane, policy. Why would a lender be willing to pay someone to borrow money, while still bearing the risk of default? Nonetheless, such policies have emerged because there are times when central banks exhaust all monetary easing measures, pushing interest rates to zero, yet fail to spur economic growth, leaving them seemingly “powerless” and resorting to negative interest rates.

Understanding Negative Interest Rates

What is Negative Interest Rate?

Interest rates are typically defined as the cost of borrowing money. For example, an interest rate of 2% per annum means that borrowers must pay an additional $2 per year for every $100 borrowed. So, what does it mean when we have negative interest rates? Is the borrower paid interest instead of being charged? Suppose a rate of -2%, it means that the bank pays the borrower $2 per year for every $100 borrowed.

Negative interest rates occur when borrowers receive interest from lenders. Although highly unconventional, it has occurred during economic downturns when monetary policies and market pressures have pushed nominal interest rates below zero.

Why Use Negative Interest Rates?

While real interest rates can be negative if inflation surpasses nominal interest rates, theoretically, nominal interest rates are bounded by zero. When interest rates hit zero and the economy still requires further stimulus, negative interest rates become a last resort.

Negative interest rates may occur during periods of deflation. During these times, individuals and businesses tend to hoard cash instead of spending it. This can lead to a sharp decrease in aggregate demand, causing prices of goods to fall, GDP growth to stall, and unemployment rates to rise. To combat deflation, monetary policy easing is typically employed, with central banks cutting interest rates. However, when deflation is severe, even lowering interest rates to zero may not be enough to stimulate borrowing and lending. This necessitates the use of the unprecedented measure of negative interest rates.

Understanding Negative Interest Rates

Countries that Have Implemented Negative Interest Rates

Sweden was the first country to implement this policy: In July 2009, the Swedish central bank (Riksbank) cut the overnight deposit rate to -0.25%. Subsequently, the European Central Bank (ECB) also adopted this policy by lowering the deposit rate to -0.1% in June 2014, and currently, this rate has been pushed down to -0.5%. Other countries have since followed suit with negative interest rate policies, such as Switzerland (-0.75%) and Japan (-0.1%). This monetary policy tool is designed to stimulate economic growth through spending and investment; individuals are encouraged to spend cash rather than hoard it in banks, as they would incur losses.

Why Implement This Drastic Measure?

In February 2015, Europe witnessed a deflation rate of 0.6%, raising concerns among policymakers that Europe was at risk of falling into a deflationary spiral. The ECB employed negative interest rates to prevent this from happening.

Understanding Negative Interest Rates

Risks of Negative Interest Rates

In theory, negative interest rates would stimulate economic activity and prevent deflation, but policymakers remain cautious because this policy could backfire. Negative interest rates could reduce bank profits, potentially leading to banks being less willing to lend.

Moreover, there is nothing stopping individuals from withdrawing their deposits and storing them in safes. The initial danger of negative interest rates might be a bank run, and a cash shortage at banks could lead to interest rates rising again – completely contrary to the initial purpose of negative interest rates.