We have all heard about our family and friends reveling when the interest rate of borrowing goes down and complain when the interest rates of fixed deposits fall. However, imagine a scenario when these interest rates go negative! You will be able to avail loans from banks at the lowest rates and be encouraged to increase your consumption. This is a reality in some countries and many other nations are debating its viability.
This article deals with what interest rates are and how they work. It will also explain how negative interest rates are not as rosy as they first sound but are just as absurd in practice. The discussion on these rates has been increasing as the impact of the COVID-19 on the economy is becoming more real and people are proposing unconventional monetary policies to tackle these problems.
There is no doubt that the COVID-19 pandemic has adversely hit the social and economic life on a global level. With lives at a virtual suspension, the negative impact on a country’s economy has been immense resulting in the overall fall in GDP growth, rise in unemployment rates, increasing recessionary trends, and loss of consumer confidence. To combat this devastating situation, there has been a demand calling for the adoption of negative interest rate policy, inter alia.
A negative interest rate policy is just as suggested by its name; loans are given at a negative rate of interest. This essentially results in borrowers (the commercial banks and financial institutions) having to pay money to deposit money while earning money by taking out loans from the central bank. This reduces the cost of borrowing and incentivize borrowing, spending, and investing rather than depositing cash with banks or hoarding. This peculiar monetary policy used to combat the deflationary cycle has been implemented in countries like Japan, Denmark, Switzerland, and other European countries.
To understand the theory behind the negative interest rate, let us go back to the basics of economics. During deflationary periods, individuals and entities tend to hoard money rather than spend money due to loss of confidence. This results in a downfall in demand and there is a risk of being stuck in a deflationary spiral resulting in reduced production, employment, and prices of goods and services. To avoid this situation, a negative interest rate policy can be adopted.
Usually, the central banks control and influence the use of funds at the commercial bank’s disposal by setting ratios that determine the amount a bank has to hold in reserve and rates at which the commercial banks can either borrow from the central bank or deposit at the central bank. These rates in effect, influence the amount lent out by banks and the rate of interest at which commercial banks or financial institutions will lend out money to consumers. The central bank, through its monetary policy, pumps money into the economy when needed and contracts the money supply as required.
Under the negative interest rate policy, the central bank will charge money from banks and financial institutions to store their excess reserves at the central bank rather than paying them interest. This encourages banks to loan out money rather than keep it in reserve to avoid the penalty of excess reserve. The benefit of a lowered cost of borrowing may be passed on to the consumers as banks can lend money at a lower rate while still earning profits, consequently promoting economic growth by keeping businesses that are short on cash, afloat. The low cost of borrowing theoretically results in an increase in consumer spending and investment as keeping money in the bank account is not as beneficial due to lower returns.
This policy allows an economy to prevent a deflationary cycle and increase liquidity and productivity in the market and thereby, raising employment and GDP. However, this policy is quite a controversial policy, and therefore, countries are apprehensive about adopting it even as a last resort.
Relevance during the COVID-19 Pandemic
Nevertheless, these unprecedented times call for unprecedented actions to combat these issues. The COVID-19 crisis has shrunk advanced and developing economies and intense deflationary conditions are predicted due to a lockdown on demand. Negative interest rate policy may be a way out of the dreaded deflationary cycle. This policy has come to the forefront in policy-making as apart from facilitating commerce and raising GDP growth, the negative interest rate also weakens the currency thereby, potentially increasing exports as products from the country would be comparably cheaper than products from other countries. Therefore, some people have asserted that this expansionary monetary policy may help mitigate the looming economic crisis even while others contend that it will leave the economy worse-off.
This debate has intensified as Donald Trump advocated for negative interest rate while Jerome Powell, Chair of the Federal Reserve Bank rejected it. The approach most countries are taking is to roll out stimulus measures including a reduction in interest rates while not completely ruling out the possibility of adopting a negative interest rate policy. The apprehension regarding the negative interest rate policy is largely due to the lack of conclusive proof about the effectiveness of the policy.
Economies all over the world have experienced a drastic fall in most sectors and are providing stimulus packages to revitalize economies to mitigate deflationary effects. However, the steady downward trend of the real interest rate is not enough to sustain the economies and reach target inflation rates. A large amount of investment is needed to boost the economy as businesses now require long-term loans to remain afloat.
Without a vaccine in the near future, the situation is becoming increasingly dire and the existing fiscal and monetary policies may not be enough to stimulate demand in the market. The panic is causing people to hoard money regardless of the reduced interest rates and disincentives. Negative interest rate is a very drastic policy, but this may be the only solution left to the countries when their interest rates are lower than have been in the past few years. This would stimulate the economy the same way reducing interest rates generally do in practice and provide countries with more firepower to combat the economic slowdown. However, negative interest rates have their limitations and risks as we will see below.
Consequences of Negative Interest Rates
A major concern with the negative interest rate is the impact on the profit margins of banks. Banks earn a low profit on loans as interest rates are reduced. On the other hand, banks are reluctant to pass on this loss to the depositors and charge for deposits as this would result in people withdrawing money from the bank and storing it in vaults/lockers at home where they will not be charged for saving. Banks can adjust the losses by charging increased fees on overdrafts and other services. However, long-drawn negative rates could hurt the financial institutions resulting in their exit and disruptions in the credit creation in the economy.
For the consumers, the return on bonds or fixed deposits or savings accounts will be minimal. Individuals and businesses will be able to borrow money at very low-interest rates. However, it is still unclear whether consumers would actually spend the money and pump it into the economy to increase productivity. Businesses may choose to focus on short-term financial activities rather than a long-term plan focused on productivity growth leading to unintended outcomes.
Additionally, the long-term effects of using a negative interest policy are not known due to a lack of evidence. It is also unclear how effective this policy is. While countries have employed negative interest rate, the information about its effectiveness and side-effects is in the processing stage and empirical evidence is undetermined. For example, Sweden has done away with negative interest rate after five years experiment. During this period, the inflation in the country did rise as desired, however, it is unclear how much of it can be attributed to the negative interest rate as the inflation in the European area rose at a similar pattern.
Further, the correlation between the negative interest rate and consumption is unclear. While there is disagreement about whether the policy has succeeded in Sweden or not, there is a unanimous opinion that long-term use of the policy would prove to be detrimental as it causes a huge burden on bank profitability and credit creation capabilities. To effectively implement negative interest rates, the structure of banks may need to be tweaked to absorb the negative rates.
In light of this, the reluctance of countries to employ negative interest rates is well-founded. The cost may well exceed the benefits, so the preference is zero interest rates rather than going negative. However, the choice may be made for them as the coronavirus situation is unlikely to be resolved soon, and cutting interest rates is not stimulating target demand. While this is not a complete solution, stimulus fiscal policies, negative interest rates, and real incentives to spend money would be a start to combat the post-COVID-19 economic pressures. Normal fiscal and monetary policies may not be a sufficient stimulus for the economy as these are not normal times. Unconventional methods may need to be adopted and the negative interest rate is one such unconventional method.
Despite the reservations regarding the policy, it cannot be completely set aside and demands consideration at a time when economies show no signs of recovering, and the pandemic is bound to have a lasting effect on the social life of individuals influencing their consumption and decision making. The government and the central banks need to form a cohesive action plan to tackle the upcoming pressures.
Is India likely to get negative interest rates?
Since the coronavirus crisis, the Reserve Bank of India has been reducing repo rate and reverse repo rate leading to Indian banks reducing their lending rates. Real interest rate (interest rate after inflation is taken into account) has turned negative in India due to increased CPI inflation caused by supply constraints and is expected to stay that way for a few months. This is, however, unlikely to hurt the financial savings of households according to an economic advisor at SBI given the uncertainty due to the pandemic. People are continuing to save money despite the negative real interest rate. It is probable that the RBI will not be reducing its interest rate further and instead of looking at other measures to protect the growth from the impact of the COVID-19 pandemic. The situation is tricky as inflation continues to rise even when the growth of the economy shows a downward trend. India is far from adopting the negative interest rate unless there is a consistent deflation which is in itself an unlikely scenario.
Has negative interest rate been successful in other countries?
Countries that use negative interest rates have seen a rise in their inflation levels. Therefore, to an extent these have been a success. However, various other factors affect the inflation levels and it is unclear how much negative interest rates have contributed towards it. Further, it is too early to call these a success as there simply isn’t enough data and the evidence available gives mixed signals about the effectiveness of the rates. However, the impact of the policy to weaken the currency is much more successful.