Negative Interest Rates (Financial Economics)

Policy interest rates in a growing number of countries have reached zero or moved negative as central banks have attempted to use extraordinary monetary policy measures to support demand, output and confidence in struggling countries at risk of price deflation.

Reasons for using Negative Interest Rates

Negative interest rates are designed to:

1. Get banks lending – they will pay the central bank interest for holding money on deposit with them
2. Bring about a reduction in real interest rates – which might in turn stimulate increased business investment
3. Negative rates are partly designed to cause an outflow of hot money thereby depreciating the exchange rate
4. Main aim of negative rates is to lower the risks to output, profits, employment & wages from deflation

Key evaluation point: Negative interest rates are a sign that conventional monetary policy of low rates may have stopped being effective in reflating debt-ridden economies.

Risks from Negative Interest Rates

1. Negative interest rates can lower bank profitability by narrowing the interest-rate margins between savings and loans rates – this is a threat to their long run stability
2. Negative rate can also banks to take excessive risks in search of higher returns - leading to asset bubbles including the housing market (another housing boom?)
3. Lower interest rates on deposits may cause households and businesses to hoard cash rather than spend/invest
4. Pension and insurance companies may struggle to meet their long term liabilities if long term interest rates (yields) are close to zero or below
5. Economy may become dependent on ultra-low interest rates whereas expansionary fiscal policy might be more effective in stimulating real investment and growth.
6. Keynesians support the key role for expansionary fiscal policy when monetary policy is being ineffective