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The Bank of Japan (BoJ), European Central Bank (ECB) and the central banks in several other European countries, such as Denmark, 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, the proponents of the policy hope, will stimulate the economy on a growth trajectory as other conventional monetary policy options have been exhausted.
Increasingly more policy makers are warming up to the idea. Governor Haruhiko Kuroda of Bank of Japan (BoJ) recently said that he would further loosen the monetary policy to bolster growth and inflation via policies including negative interest rates. He 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 has become quite counterintuitive 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 their money at the bank. Implicitly the depositors are encouraged to spend the money rather than save it. Negative interest rates will, therefore, reduce costs of borrowing and incentivise investment and consumer spending. In countries, such as Denmark and Switzerland negative interest rates are 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.
We must bear in mind that we are not talking about negative real interest rates which are adjusted for changes in the price level. 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.
This policy has not been practised before and there is a well-known dictum that interest should not go below zero. But below-zero interest rate has now 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. 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 Gross Domestic Product (GDP) to shrink which in turn pushes the public debt/GDP 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.
Theoretically, negative interest rates should reduce borrowing costs thus stimulatie demand for borrowing. That is not happening so far and savings rates are not going down despite returns on savings are very unattractive. The low cost of capital resulted in opportunity cost of alternative investment very low. This makes investment decisions very difficult thus dampening investment.
Negative interest rate is unlikely to hit the retail banking sector soon for the fear of losing customers but a few banks have already begun to charge very large deposit holders. If banks continue to absorb a part or the 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. 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 ther, it is more advisable for these banks to lend each other in currencies, such as Swiss Francs or 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 in the zone of near zero to negative interest rates. It is simply because the central banks of many developed countries 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 making not much difference in achieving the growth objective. Negative interest rates are symptoms of desperation thus forcing these countries to explore new policy tools. This appears to be marking the limit of the power of central banks to steer the economy to the desired direction and ineffectiveness of their policy tools.
The writer is an independent economic and political analyst.
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