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Negative Interest Rates Explained

Negative interest rates are one of the key signals of an impending recession. They are typically applied when the monetary policy requires a change within the system in order to push the interest rates to the nominal zero bound. In the past couple of years, the central banks have experimented with negative interest rates in order to stimulate and boost weak economies.

Still, the most important thing you need to know is how these negative interest rates affect you. Keep reading to find out if negative interest rates are as beneficial as they seem.

Just the Nuggets

  • Negative interest rates are usually frowned upon by the central banks and used as a last resort for sparking economic growth.
  • In this case, the interest rates are pushed below zero in order to encourage spending instead of hoarding money.
  • Some of the strongest economies of the world have adopted negative interest rates, including Japan, United States, Denmark, and the United Kingdom.
  • The benefits of negative interest rates are the economic push for the country as well as lower debts in comparison, while the downsides are lower returns on your savings and excess liquidity.

How Do Negative Interest Rates Work?

Negative interest rates are the monetary policy instrument used to encourage lending. This is considered an unconventional monetary move, considering that lending is usually encouraged by making it cost-ineffective for commercial banks to hold onto their resources. Instead, they are encouraged to up their lending activities in order to create a new balance in this environment.

During the states of deep economic recession, countries and their respective central banks have noticed that negative interest rates could be applied as a useful tool to help stabilize the economy. During the majority of the 20th century, economic and financial experts have started to uncover the new use and direction the interest rates could take. 

Previously, during the entire financial history of the world, it was considered that interest rates could only go as low as zero. However, central banks in Europe and Japan were the very first to demonstrate that the rates could go below zero, as a response to slow down economic growth or deep deflation. The basic principle of this decision is to incentivize the banks more to make loans.

The Basics

Negative interest rates happen when commercial banks keep the money by charging you interest instead of paying it to you. They are usually implemented when banks and other institutions are inclined to hoard the money (during deflationary periods, for example). This way, the monetary policy of a central bank is encouraging them to break out of that comfort zone and keep the money flowing through the economic activities, as it should be.

Zero Bound

The negative interest rates are tied to the zero-bound limit. This term refers to the lowest level the interest rate could fall to. 

Logically, this limit would be zero. However, there are many countries that have started to adopt policies where the target interest rate can actually go below zero. 

For example, in Switzerland, this level is -0.75% while in Japan, the target rate for mid-2020 was -0.1%. 

This is not unusual, since the central banks are manipulating zero bound in order to stimulate the economy or create lasting recovery. This tool was widely used during the Great Recession when the central banks were pushing the zero bound below the numerical level to encourage growth through spending.

Zero bound as a method is used in another important instance—when the country needs to take charge of the highly fluid economy. As opposed to stagnation, here, the central banks are using the zero bound and target interest rates to try and take control of the unpredictable financial trends present in the country’s economy.

What is the main use of the zero bound? 

Well, zero bound is a signal indicating the lowest level the interest rates can drop to. What happens then is, in case the economy is still underperforming, the central bank cannot provide stimulus any longer. This scenario is known as the liquidity trap

Liquidity Trap

The liquidity trap is a contradictory economic situation in which interest rates are quite low while the savings rates are unusually high. This produces an ineffective monetary policy, which is why it is considered mainly as a consequence of psychological behavior. 

The term liquidity trap was first introduced by the economist John Maynard Keynes, who used it to describe a situation where the consumers choose to avoid bonds and keep their money in cash. This is based on their psychological belief that the interest rates will soon rise, pushing the bond prices down.

During that same time, the banks are unable to bring the interest rates further down to stimulate the economy, which is when the liquidity trap occurs. In this case, there are several things banks could try doing to get out of a liquidity trap, including bringing up interest rates. However, this is an unreliable method since there is no guarantee that it will work. Also, the rise of the interest rates is based on the expectation that the situation will sort itself out, which is not always the case.

When Do Negative Interest Rates Occur?

A clear signal of negative interest rates pending and coming into action is the prolonged deflationary period. During these times, people tend to hold onto their money instead of spending it, thus creating a vacuum in the monetary system of their country. 

The thing about this situation is—the longer you hold onto your money, the lower its value goes down. This creates a sharp decline in demand, which is why your money’s worth drops drastically as time passes.

In this situation, the looser monetary policies can be effective in the long run. One of the most useful tools of a loose monetary policy is bringing in the negative interest rates. 

However, it should be noted that central banks are quite hesitant to make that decision since the outcome can be unpredictable. That is why banks usually commit to reviewing these policies regularly, in case there is a need to change or revoke them.

It is important to note that negative interest rates affect all parts and sectors of the economy. In a negative interest rate environment, typical occurrences are the rise of the unemployment rate, falling prices, and halts in production and output. Here, the looser monetary policy is adjusted to stop the economic stagnation and help get things up and running again.

Negative Interest Rates—An Example

In the past couple of years, central banks in Europe and Japan have implemented a new negative interest rate policy in order to produce economic growth in these areas. 

The core principle of this policy is to encourage investments and spending so the consumers would spend money instead of holding onto it or store it in the bank. This brings the possibility of an impending loss in value. So far, it is still unclear how effective this policy is.

Why Adopt Negative Interest Rates?

At first thought, adopting negative interest rates may seem counterproductive. 

Why would you pay someone to borrow money from you, since you are taking on enough risk as it is? 

However, the wide financial experience in this area has proven that the negative interest rates are quite effective in the long run. Sometimes, they can even be the lifeboat of a stagnating economy. A negative interest rate policy of a central bank is a drastic measure a country uses to stop the further derailing of its financial system.

What many people today tend to disregard or forget about is the fact that when you put your money into a bank, you are basically becoming a lender yourself. Therefore, your money is subjected to all the factors taking place every day in the financial environment. Negative interest rates are one of the ways to keep that in check.

Many countries today have noticed that there are a lot more advantages to adopting negative interest rates. Despite these countries historically having strong and impermeable economies, things are constantly changing and evolving. 

As a result of the ongoing COVID-19 pandemic as well as previous occurrences (global economic crisis, migrant crisis, etc.), here are the countries who have adopted negative interest rates.

United States

After the COVID-19 pandemic hit the United States back in late January, the Federal Reserve was quick to take precautions and shed the interest rates near zero. This brought the interest rates back to the level they had for almost 10 years after the global economic crisis. 

Both the US President Donald Trump and the Fed Chairman Jerome Powell were hesitant to drop the interest rates, with Powell being adamant to turn to other tools first. The general response back then was mixed, so it was impossible to detect how useful this would be for the US economy.

The basic idea for this new policy was simple—to create lower borrowing costs and essentially punish the lenders who tend to hoard their cash. 

However, that would impose another consequence in practice. It is widely known that US banks are hesitant when it comes to charging fees for deposits. This would create quite a gap in the long run the economists were quick to warn about. Some of the more sceptic experts were actually worried about the reverse rates, which would backfire on the entire economy if the negative interest rates prevail.

However, the Fed was encouraged by the proud example of the European Central Bank (ECB), which introduced its negative interest rates a few months earlier in September 2019. Namely, the ECB was able to contain the possible downsides of this decision by reversing the negative interest rates for the first time in 10 years with Sweden. 

Still, the negative interest rates in the US could mean much lower returns on savings in the long run, despite many advantages.

United Kingdom

Soon after the US decided to dab in the risky area of negative interest rates, the United Kingdom soon followed with their decision officially coming into action in March 2020. 

The policy of negative interest rates has been present in Europe for quite awhile—since the global economic crisis was announced back in 2008. Since then, the UK was able to successfully keep the rates in the positive territory, but all good things must come to an end.

The Bank of England has started to seriously consider the introduction of negative interest rates since the global health crisis. In the case of the United Kingdom, this policy would be quite beneficial for the stock market, in particular. Thanks to cheap debt conditions, companies and individuals would be encouraged to invest even more in this sector—which would spark faster economic growth.

However, the most important downside of this decision is its negative effect on the pound. The UK’s national currency is regularly struggling against the euro, so this policy would only add to the pressure. This is particularly damaging to companies selling imported products in the UK.

Denmark

The controversial Danish experience with the negative interest rates imposes an unusual principle that the experts are recently adopting. Namely, the country’s banks were adamant about not introducing the negative interest rates and keeping them fixed instead. This was a popular opinion since 2012, and the financial analysts are now claiming that the interest rates have dropped to the negative territory precisely because of that commitment.

Denmark is considered one of the few countries that do not have a reversal rate present, despite the fact that this policy has been present for almost eight years. Also, the threshold for the introduction of the negative interest rates has been continuously declining, which is another unique occurrence.

Switzerland

The negative interest rate policy in this country is one of the longest-standing policies in the world in this area. 

Lately, Switzerland has set a target rate of -0.75% for its economy. Many argue that this decision is only further benefiting the rich in the country, creating a lasting wealth gap. 

Considering its main features, the experts are warning about the evolving and skewed perception of risks and investments in the country that could have a lasting and damaging impact on the entire economy.

Japan

Japan is no stranger to the negative interest rates policy. 

The latest has come into action back in 2016 because of the sudden rise in its national currency—the Japanese yen. Though this may seem quite unusual to try to stop the growth of your own currency, it was actually a smart move on their part. Namely, the sudden spike in the yen would significantly damage the Japanese economy, which is mainly depending on the export. 

As a result of this policy, among others, the Japanese yen is now the single most stable and liquid currency in the world.

Pros and Cons

Negative interest rates can be a driving force for successful economies in the world. 

  1. They are able to encourage economic growth and create a lasting balance in investing and spending. 
  2. When used properly, negative interest rates can significantly improve other sectors of the country’s economy which were previously lacking. 
  3. Also, negative interest rates can impose lower costs on your obligations such as mortgage and other debt in the long run—not only for the individual but for the country, as well.

However, the interest rates are hanging below zero. 

  1. This means much lower returns in all sectors of investing and saving. This includes your pension funds, savings accounts, and other types of banking. 
  2. This also imposes lower profitability for the commercial banks, since they are basically paying for someone to lend money to them which is already a risk of its own.
  3. Lastly, the negative interest rates policy is quite unpredictable and contradictory. It could produce unexpected results, such as even bigger hesitation for the consumers to use their money, as well as excessive liquidity which can be quite damaging.

Closing Notes

Negative interest rates are beneficial for a stagnating economy and slow economic growth, as well as in times of significant deflation. They encourage you to join the economic activity by spending and investing your money instead of hoarding it away until it loses value. The negative interest rates can be useful for you as well since they impose lower costs on your debts. However, they could also produce a reverse effect and prolong the stagnation, as well as affect your savings with much lower returns.

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