Economics of Negative Interest Rates

In this revision video we look at the economics of negative interest rates.

We assess whether this is a sustainable form of monetary policy for central banks in some countries at risk of a deflationary depression.

A negative interest rate policy happens when a country’s central bank lowers the nominal monetary policy interest rate below zero. In other words, commercial banks must pay to lodge some od the savings balances in an account at their national central bank.

Nominal and real interest rates

• It is important to make a distinction between nominal and real interest rates when discussing a negative interest rate policy.
• The real interest rate can be negative if the nominal interest rate (e.g. on savings or charged on a loan) is below the rate of inflation
• For example: Nominal interest rate = 1%, inflation = 3%, then the real interest rate = -2%
• But what we are seeing in some countries is the nominal interest rate falling below zero
• In Europe and Japan, Central banks in recent years have started to experiment with negative interest rates to stimulate their countries’ economies
• In short this means that commercial banks are being made to pay to park their excess cash in an account at the central bank There are also some negative interest rates in the market for sovereign bonds including in Switzerland and Germany

Aims of a negative interest rate policy (NIRP)

1. Get banks lending – i.e. they will pay the central bank interest for holding money on deposit with them
2. Get people spending – if nominal interest rates on saving become negative
3. Get government borrowing – low bond yields are an opportunity to invest e.g. in infrastructure
4. Bring about a reduction in real interest rates – which might then stimulate increased business investment and aggregate demand (AD)
5. Negative rates are partly designed to cause an outflow of hot money thereby depreciating a country’s exchange rate

Evaluation: Risks from a negative interest rate policy

1. Negative interest rates can cut commercial bank profitability by reducing the interest-rate margins between savings and loans rates – banks may also raise the fees charged for arranging new loans
2. Negative rate may cause banks to take excessive risks in search of higher returns – perhaps leading to future asset bubbles including the housing market
3. Harder to sell new issues of government debt if bond yields are negative
4. Lower interest rates on deposits may cause households and businesses to hoard cash rather than spend/invest – they might delay cashing cheques
5. Pension and insurance companies may struggle to meet their long-term liabilities if long term interest rates (yields) are close to zero or below
6. Economy may be over-dependent on ultra-low interest rates – leading to the survival of zombie firms