Negative Interest Rates Analysis

In the contemporary financial environment, individuals who deposit money in the banks earn interest from their deposits. Similarly, commercial banks also receive interests from lodging funds with central banks. In other words, banks compensate savers by adding some percentages of the amount saved in the banks. In a sense, savers are lending their money to banks in order to be used elsewhere. In return, banks compensate savers interest incomes. Meanwhile, the interest rates are quoted as APY (annual percentage of yield) and savings account earns 3% APY. However, negative interest rates reverse this arrangement where savers or depositors are obliged to pay banks for holding their money. Moreover, central banks penalize commercial banks for depositing their funds with them. For example, The ECB (European Central Bank), some smaller European banks, and Bank of Japan have introduced the negative interest rate policy where banks, as well as other financial institutions, will have to pay charges for allowing central banks to keep their money. However, there are genuine reasons for introducing this policy.

The objective of this policy paper is to investigate the reasons for introducing the negative interest rates and the risks associated with the policy.

Since 2014, the ECB (European Central Bank) has become the first major bank that has moved out of the traditional marginal policy to the negative interest rate policy to address the macroeconomic challenges and achieving price stability. The major goals for introducing the negative interest rates are to counter low inflation rates, and addressing currency appreciation pressures. Some central banks introduce negative interest rates to reduce the cost of holding excess reserves and allowing the reserve to pass through money markets. For example, Japan and Eurozone introduced the negative interest rates to anchor inflation expectation and address price stability. In Denmark, the goal is to counter exchange rate pressures and safe haven inflows. However, Switzerland objective's for introducing negative interest rate is to reduce deflationary and appreciation pressures.

Barua and Majumdar (2016) point out that the interest rate of ECB (European Central Bank) is below zero. However, data in Eurozone reveals that ECB has recorded successes from negative interest policy because banks and households are recovering from the sovereign debt crisis and global financial crisis. The unorthodox policies assist in pushing up the aggregate demand, and liquidity thereby pushing the prices up and stimulate firm propensity to initiate capital investment. A robust argument in favor of negative interest policy is to counter deflation, forcing banks to lend more thereby reducing their excess reserves. A way of using the negative interest policy is to boost economic growth since banks naturally do not like to hold excess reserves and prefer lending out their cash reserves. However, during the period of financial risks, banks will prefer putting their excess reserve with the central banks, Thus, when banks are discouraged from putting their reserves with the central bank, the alternative left for them is to lend out their funds thereby boosting the aggregate demand and investments. Thus, the major goal for introducing the negative interest rates is to encourage commercial banks increasing their lending capacity thereby stimulating economic growth. The strategy will encourage commercial banks to invest their excess reserves in the public. Since commercial banks and other financial Institutions have realized that they will lose part of their funds by depositing them with the central banks, they will be forced to lend out their funds to the public. In this sense, the central banks use the negative interest rates to stimulate the sagging economies. More importantly, when depositors realize that they are not going to get benefits from depositing their funds in the commercial banks, they will prefer spending the funds rather than allowing the funds eroding over time. (Weing, 2015).

The goal of negative interest rate is also to discourage banks and other financial institutions from hoarding their cash and be forced to invest their funds or lend them out. Jobst, & Lin (2016) argue that "the European Central Bank (ECB)" (p 1) introduced a policy of negative interest rates to achieve price stability since it is currently contributing to a modest credit expansion. In general, the negative interest policy assists in boosting the aggregate demand because banks will be venturing in more investments. Moreover, negative interest rates make exchange rate depreciate providing incentives to move the capital to higher-yield investment jurisdictions. (Rostagno et al. 2016).

Caballero et al. (2008) argue that negative interest rates assist in easing financial constraints that borrowers may face in the short run. Additionally, the policy can increase a re-distributional effect of monetary policy on income and wealth. The central banks also introduced the lower interest rates to support investment and consumption of products of liquidity constraints and raising overall aggregated demand. Humphrey (2015) supports the argument of previous authors by pointing out that negative interest rate increase aggregate demand for cash since banks will be forced to move a portion of their balances into domestic loans thereby stimulating the aggregate demand. The goal of negative interest rates is to allow banks to purchase foreign short-term assets and securities to stimulate exportation and aggregate demand. Thus, a movement of the fund to other countries will assist in maintaining favorable exchange rates to trading partners.

Meanwhile "Negative rates might send investors in search of better returns abroad, leading to depreciation of the currency. That would raise the price of imports, helping to combat deflation and giving a growth-enhancing boost to exporters. Since the ECB introduced negative deposit rates the euro has fallen against the dollar by nearly 20%". (The Economist, 2016 p 1)

Despite the benefits associated with negative interest rates, there are opposing argument believing that the policy carries some financial risks. Abozaid, & Garin, (2016) point out that economic theory had disregarded the option of negative interest rates to be insignificant to the economic growth. Moreover, a reduction in interest rates will make depositors be worse off while borrowers benefit from the policy of negative interest rates. The policy is also not beneficial to elderly people because these age groups have accumulated savings, thus, negative interest rates will make them be worse off in the long run because of a decline in their income. Moreover, negative interest rates will reduce the propensity to save since people have realized that their income will decline by saving their cash in the banks. Thus, the depositor will prefer putting large percentages of their money at home rather than putting their funds in the banks. The risk aspect of the policy is that people will prefer carrying cash rather than using bank credit cards to make purchases exposing consumer's risks of being attacked by aggressors.

"Some economists consider this dangerous. Some reckon it shouldn't be possible at all. Since cash carries an implicit rate of interest of 0%, consumers might well respond to negative rates by withdrawing money from banks and stuffing it in their mattresses. The resulting shortage of loanable funds would push interest rates up (though perhaps not before causing an economy-crushing bank run)". (The Economists, 2015 p 1).

Negative interest rates can also make commercial banks short of cash because of low propensity to save, which will reduce banks' ability to carry out their traditional lending objective. A report by Risk Bank (2016) shows that NIRP has an impact on bank profitability in Europe. Essentially, banks need to have excess capital to provide loans to companies and households. At Eurozone, many banks have recorded low profitability for a long time thereby having negative effects on capitalization and limiting their supply for loans.

Despite the risky aspects of negative interest rate, the policy is still beneficial to the whole economy because it has improved financial conditions of many advanced economies. For example, the policy is effective in reducing liquidity and money market rates by lowering bank lending rates for both households and corporate organizations. The policy has also reduced corporate and retail deposit rates thereby supporting the credit growth. The NIR (negative interest rate) policy has also reduced the costs associated with the interbank lending thereby strengthening lower bank rates. The NIRP has also improved financial conditions of the Eurozone and improved an expansion of credit.