At many of the world’s central banks, setting key interest rates is the primary tool for conducting monetary policy and stabilizing economic activity. When central bankers are worried about inflation or an economy expanding too quickly, they can raise rates and increase the cost of borrowing, giving households and businesses more reason to save their money, rather than spending or investing.
Similarly, in the midst of an economic recession, central banks can slash interest rates, which cuts the cost of borrowing money, encouraging businesses to invest and households to spend more.
So What’s the Deal with Negative Rates?
However, when interest rates approach what economists refer to as the “zero lower bound”, central banks supposedly lose their ability to stimulate the economy by further cutting interest rates, and conventional theories surrounding monetary policy come into question.
This is why when a central bank introduces negative interest rates, it is seen as pursuing a form of what is called unconventional monetary policy.
Despite cautionary rhetoric from many respected economists, central bankers around the world have chosen to embrace negative interest rates. With about 25% of world GDP coming from countries with negative interest rates, it seems they are here to stay.
Switzerland and Denmark both pursued sub-zero rates in an effort to curb currency appreciation and slow hot money from entering their economies. Japan has been hovering around the zero lower bound for well over a decade now, and in 2016 they went negative.
The Bank of Japan, however, instituted negative rates in an attempt to drive up demand and bring the economy out of years of stagnation. The European Central Bank has also pursued similar interest rate policies with uncertain success.
So What Does that Mean?
Interest rates determine the cost of borrowing or the interest received on deposits. Much like a person receives interest on deposits held at their bank, commercial banks hold large reserves at their central banks, which also receive interest. In the case of negative interest rates, banks no longer receive interest on their reserves, but they are instead charged a fee by the central bank for holding their money.
This practice runs counter to the intuition behind traditional banking practices.
If banks or individuals have to pay a fee to store their money, they would theoretically be better off just holding onto that cash themselves, seeing as cash can’t incur a negative interest rate. Hence, some worry that cash hoarding and shrinking deposits may discourage banks from lending.
Negative rates also put significant pressure on bank profits, which may contribute to large sell-offs or indirectly restrict economic growth. Alternative Bank Schweiz boss Martin Rohner noted the Swiss National Bank’s introduction of negative rates had cost the lender “pretty much the equivalent of [their] entire annual profit” for 2014.
Are Negative Rates Effective?
A Bloomberg survey of economists rated the negative interest rate policies of Switzerland and Denmark as effective, while Japan and the ECB were deemed ineffective.
In all, negative interest rates as a monetary policy tool seem to be more effective for controlling currency appreciation than they are for stimulating demand and economic growth.
In theory, a charge on deposits in central bank reserves would incentivize member banks to avoid that loss and invest their money elsewhere in the form of loans or other assets. This, in turn, would boost the economy. On a macroeconomic level, it would discourage savings while encouraging investment and consumption, leading to increased aggregate demand.
For now, negative interest rates seem to be a feasible tool for controlling currency appreciation, curbing deflationary trends, and incentivizing investment. However, they are a relatively new instrument of monetary policy, meaning we do not have data or evidence of its potential long-term impacts on the economy.