Negative Interest Rate Policy: Reasons, Risks, and Impact

Introduction

In the contemporary financial environment, individuals who deposit money in banks earn interest on their deposits. Similarly, commercial banks also receive interest from lodging funds with central banks. In other words, banks compensate savers by adding a percentage of the amount saved. In a sense, savers are lending their money to banks so that it may be used elsewhere, and in return, banks compensate them with interest income. Interest rates are typically quoted as APY (annual percentage yield); for example, a savings account might earn 3% APY.

Negative interest rates reverse this arrangement entirely: savers or depositors are obliged to pay banks for holding their money, and central banks penalize commercial banks for depositing funds with them. For example, the ECB (European Central Bank), several smaller European banks, and the Bank of Japan have all introduced negative interest rate policies under which banks and other financial institutions must pay charges for allowing central banks to hold their reserves. Despite the counterintuitive nature of this policy, there are genuine macroeconomic reasons for its introduction.

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

Reasons for Introducing Negative Interest Rates

Since 2014, the ECB has been the first major central bank to move away from traditional marginal policy toward a negative interest rate policy in order to address macroeconomic challenges and achieve price stability. The major goals for introducing negative interest rates are to counter low inflation, address currency appreciation pressures, and reduce the cost of holding excess reserves — allowing those reserves to pass through money markets. For example, Japan and the Eurozone introduced negative interest rates to anchor inflation expectations and address price stability. In Denmark, the goal was to counter exchange rate pressures and safe-haven capital inflows, while Switzerland's objective was to reduce deflationary and appreciation pressures.

Barua and Majumdar (2016) point out that the ECB's interest rate has moved below zero. Data from the Eurozone reveals that the ECB has recorded successes from negative interest rate policy, as banks and households recover from the sovereign debt crisis and the global financial crisis. These unorthodox policies help push up aggregate demand and liquidity, thereby raising prices and stimulating firms' propensity to initiate capital investment. A robust argument in favor of negative interest rate policy is that it counters deflation by forcing banks to lend more, thereby reducing their excess reserves.

One key mechanism is that banks naturally prefer not to hold excess reserves and instead prefer to lend out their cash. However, during periods of financial risk, banks tend to park their excess reserves with central banks. When banks are discouraged from doing so, the logical alternative is to lend those funds to businesses and individuals, thereby boosting aggregate demand and investment. Thus, a central goal of negative interest rates is to encourage commercial banks to increase their lending capacity and stimulate economic growth. Since commercial banks and other financial institutions realize they will lose part of their funds by depositing them with the central bank, they are effectively compelled to lend to the public. In this sense, central banks use negative interest rates to stimulate sagging economies. Furthermore, when depositors realize they will receive no benefit — and may incur a cost — from depositing funds in commercial banks, they may prefer to spend those funds rather than allow them to erode over time (Weing, 2015).

The goal of negative interest rate policy is also to discourage banks and other financial institutions from hoarding cash and to force them to invest or lend their funds. Jobst and Lin (2016) argue that the ECB introduced negative interest rate policy to achieve price stability, noting that it is currently contributing to a modest credit expansion. In general, negative interest rate policy boosts aggregate demand because banks venture into more investments. Moreover, negative interest rates cause exchange rate depreciation, providing incentives to move capital to higher-yield investment jurisdictions (Rostagno et al., 2016).

Caballero et al. (2008) argue that negative interest rates help ease financial constraints that borrowers may face in the short run. Additionally, the policy can increase the redistributional effect of monetary policy on income and wealth. Central banks have also introduced lower interest rates to support investment and consumption among liquidity-constrained borrowers, raising overall aggregate demand. Humphrey (2015) supports this view, pointing out that negative interest rates increase aggregate demand for cash since banks are forced to move a portion of their balances into domestic loans, thereby stimulating aggregate demand. The policy also allows banks to purchase foreign short-term assets and securities to stimulate exports and aggregate demand, so that a movement of funds to other countries helps maintain favorable exchange rates with trading partners.

As The Economist (2016) observed: "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%." (p. 1)

Arguments Against Negative Interest Rates

Despite the benefits associated with negative interest rates, opposing arguments hold that the policy carries significant financial risks. Abozaid and Garin (2016) point out that economic theory had long regarded negative interest rates as insignificant to economic growth. Moreover, a reduction in interest rates makes depositors worse off while borrowers benefit. The policy is also particularly unfavorable to elderly people, who have typically accumulated savings; negative interest rates will make this group worse off in the long run because of the resulting decline in their income. Furthermore, negative interest rates reduce the propensity to save, since people recognize that their wealth will be eroded by keeping cash in banks. As a result, depositors may prefer keeping large amounts of money at home rather than in the banking system. A further risk is that people will prefer carrying cash rather than using bank credit cards, exposing consumers to the physical risk of robbery.

Some economists consider this dangerous. As The Economist (2015) noted: "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)." (p. 1)

Conclusion

The negative interest rate policy, as introduced by the Bank of Japan and the European Central Bank, was designed to stimulate economic growth. This paper shows that the major benefits associated with the policy outweigh the risks, as it has improved the economies of the Eurozone by boosting aggregate demand, reducing borrowing costs, and encouraging banks to lend rather than hoard their reserves.

References

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Barua, A. and Majumdar, R. (2016). The impact of negative interest rates: Living in the unknown, Global Economic Outlook, Q2 2016. Deloitte University Press.

Caballero, R. J., Hoshi, T., and Kashyap, A. K. (2008). Zombie lending and depressed restructuring in Japan. American Economic Review, 98(5), 1943–1977.

Faia, E., and Monacelli, T. (2007). Optimal interest rate rules, asset prices, and credit frictions. Journal of Economic Dynamics and Control, 31, 3228–3254.

Humphrey, D. (2015). Negative interest rates and the demand for cash. Journal of Payments Strategy & Systems, 9(4), 280–287.

Jobst, A. & Lin, H. (2016). Negative interest rate policy (NIRP): Implications for monetary transmission and bank profitability in the Euro Area. IMF Working Paper.

Risk Bank (2016). How do low and negative interest rates affect banks' profitability? Monetary Policy Report.

Rostagno, M. et al. (2016). Breaking through the zero line: The ECB's negative interest rate policy. Brookings Institution, Washington, DC.

The Economist (2015). Why negative interest rates have arrived — and why they won't save the global economy. The Economist.

The Economist (2016). [Negative interest rates and the euro]. The Economist.

Weing, J. (2015). Sweden imposes negative interest rate and plans bond-buying program. New York Times.