Negative interest rates: An unconventional monetary policy option

Since the Global Financial Crisis (GFC) most advanced industrialised economies have been experiencing very slow growth and also very low levels of investment and inflation with high unemployment. In these countries attempt to stimulate growth, central banks have taken increasingly very strong monetary measures. Of these monetary measures, the most contentious measure is the policy of negative interest rates. Such a policy option is considered very unconventional. Also the negative interest rate policy is a relatively new development in the field of monetary economics.  This policy is a last-ditch effort to stimulate economic growth  when all other monetary policy instruments have proved to be ineffective or failed. In theory, interest rates below zero should reduce borrowing costs for firms and households and stimulate demand for loans for investment and consumption.

It has always been the conventional belief that  central banks can not set interest rates below zero. The zero interest rate on savings is the threshold when central banks would run out of its ability to use interest rates as the monetary policy instrument effectively. This would negatively impact on savings and encourage hoarding cash because cash always has a zero interest rate. But countries where interest rates dipped below zero, have not so far triggered any large demand for cash. The probable answer to this phenomenon may lie in the assumption that most people are willing to pay for the convenience and security of not having to hold their savings in cash. But looking at it in another way it can be argued that savings are effectively taxed by negative interest rates.

More importantly, if we consider the real interest rate which measures how much of savings today will be worth, say a year ahead, is what really matters. The interest rate that we talk about is the nominal interest rate. When a nominal interest rate is adjusted for the rate of inflation, we get the real interest rate. So, the value of one's savings depends on the real interest rate not on the nominal interest rate. In the US, the Federal funds rate is 2.25 per cent while the inflation rate now is 1.8 per cent and projected to be 2.0 per cent before 2020. The federal rate is likely to come down before the last quarter of this year. Therefore, the real interest rate in the US is very close to zero. But in Switzerland both interest rate and inflation rate are negative, largely cancelling out one another making one not much worse off. In a period of moderate inflation central banks can push the real interest rates below zero to stimulate economic activity. We have had many such situations in the past. But here we are dealing with nominal interest rates below zero. 

The central bank of Denmark was the first to implement the negative interest rates regime in 2012. Now the Bank of Japan (BoJ), European Central Bank (ECB) and several other European central banks in countries such as  Sweden and Switzerland have implemented negative interest rates to stimulate growth and prevent deflation. Such a policy of negative interest rates would have been unthinkable before the Global Financial Crisis (GFC) of 2007-08. The principal objective of such a policy is to encourage borrowing and spending to spur inflation. This hopefully will stimulate the economy on a growth trajectory as other conventional monetary policy options have been exhausted.

In countries as Denmark and Switzerland negative interest rates are also used to prevent the currency appreciating too high. This will prevent speculative buying of the local currency which tends to cause appreciation of the currency thus encouraging investors to seek higher returns elsewhere.

Now increasingly more policy makers are warming up to the idea. Governor Haruhiko Kuroda of BoJ even went further recently to say that he would further loosen the monetary policy to bolster growth and inflation via policies including negative interest rates. He further emphasised that BoJ's easing efforts including negative interest rates amounted to an "extremely powerful" policy scheme. This shows that the impact of monetary policy bas become quite counter-intuitive and policy planners are no longer certain about how monetary policy instruments are going to play out.

Negative interest rates are definitely a very unorthodox monetary policy instrument and goes against the normal logic. This also possibly signals that conventional monetary policy instruments have proved ineffective to deal with the post-GFC world and new limits ought to be explored. Negative interest rates basically mean the depositors will be charged money if they want to keep money at the bank. Implicitly the depositors are encouraged to spend it rather than save it.

Now below-zero interest rate has become a reality. Even there are hints that it may further go down. The recent developments in this area show that zero lower bound is not as rigid as it was thought to be; in fact it is a reality now.  The main concern in these countries is to prevent the economy sliding into deflation or spiral of falling prices. Deflation remains the main concern in these economies because it causes nominal GDP (gross domestic product) to shrink which in turn pushes the public debt/GDP ratio to rise. As a consequence it also reduces tax revenue and makes it harder to repay the debt. Therefore, forestalling deflation has become the principal monetary policy objective now.

A very long period of very low to negative interest rates has already stirred up very deep concerns in the financial sector, in particular pension funds and insurance companies. It has also triggered deep anxieties among banks about their profit prospects.  Furthermore, excess funds held by commercial banks in central banks are also affected by negative interest rates thus forcing commercial banks to lend each other. Negative interest rates theoretically should reduce borrowing costs thus stimulating demand for borrowing. However, so far that is not happening and savings rates are not going down despite returns on savings are very unattractive now. The low cost of capital resulted in the opportunity cost of alternative investment to be very low.  This makes investment decisions very difficult thus dampening investment.

Negative interest rates are unlikely to hit the retail banking sector soon for the fear of losing customers but a few indeed have begun to charge very large deposit holders. If banks continue to absorb a part or whole cost of negative interest rates, it will negatively impact on their profit margin and make them less willing to lend.  If any one does not want to pay the bank to park their money, the alternative is to keep hard cash but that has its risks also. Therefore, individual depositors ought to weigh up the risks and benefits of keeping their money in the bank.

However, in one area negative interest rates can be used profitably. It is in the foreign exchange markets. If currency speculators believe that the currency under consideration will appreciate, one can make money even after adjusting for the negative interest rate. In Japan the negative interest rate has not increased much bank lending. Instead, the Yen has surged upward when low interest rates were expected to depreciate the currency which in turn was to boost exports.  Now Japanese financial institutions have been buying foreign securities for higher return rather than investing at home.

In effect the interest rate policy has caused households and business to rein in spending as the economic outlook looks rather very uncertain. As commercial banks have to pay the central bank to keep money there, it is more advisable for these banks to lend each other in currencies such as the Swiss Francs or the Yen or lend money to a government. This will minimise losses rather than making profits.

We need to look at the reasons why such a large number of developed countries are near zero to negative interest rates zone. It is simply because central banks of many developed countries banks have largely failed to stimulate economic growth in the aftermath of the GFC. Investment remains at a far lower level than the pre-GFC period. The policy orthodoxy also played its role in continuing with the crisis. The singular focus on using monetary policy has now run its course. Even negative interest rates appear to be making not much difference in achieving the growth objective. Negative interest rates are symptoms of desperation thus forcing the policy makers to explore new policy tools.  This also appears to be marking the limit of central banks' powers to steer the economy to the desired direction and exposing ineffectiveness of their policy tools.

Muhammad Mahmood is an independent economic and political analyst.

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