A negative interest rate policy, or NIRP, is an uncommonly used monetary policy tool where a central bank will set target interest rates at a negative value. The negative interest rates break through the lower bound of zero percent, which results in a scenario where saving costs money and borrowing brings in money. While it may seem backward, there are arguments for why implementing a negative interest rate policy could work.
A negative interest rate policy (NIRP) is a monetary policy tool where central banks set target interest rates below zero percent.
NIRP is seen as a “last resort” policy to use after exhausting all other options.
The theory in support of a NIRP is that it would encourage borrowing, incentivize lending, decrease saving, and increase spending and investment.
Theory for Implementing a Negative Interest Rate Policy
A negative interest rate policy is seen as a sort of “last resort” monetary policy tool for central banks to use during extraordinary economic times. The United States has not witnessed the implementation of negative interest rates, but the idea was floated around during the Global Financial Crisis of 2008 and the COVID-19 pandemic in 2020 as well.
Countries that implemented NIRPs in the past include Switzerland in the 1970s, Sweden in 2009, Denmark in 2012, and Japan in 2014. The European Central Bank (ECB) also set interest rates below zero in 2014.
Normally, a central bank lowering interest rates towards zero would be considered a significant lever pulled to stimulate an economy. So how could negative interest rates happen or make sense? Well, if things are bad enough, setting rates to zero simply isn’t enough. Further measures must be taken.
The idea is that setting interest rates below zero will do the following:
1. Encourage borrowing by businesses and individuals
If businesses and individuals can take out loans without incurring interest, they should be encouraged to take out loans and spend that money. If interest rates are negative, and they are even paid for the loans, it should be a no-brainer. At least, that is the thought.
2. Incentivize banks to lend more freely
Commercial banks are incentivized to lend because they, too, will feel the effects of negative interest rates when trying to deposit funds to their central bank. The central bank will charge them to hold their funds. It leads to commercial banks looking to lend those funds out instead.
In a normal environment, banks may look at applicants and refuse to lend to them based on creditworthiness and other factors. During a negative interest rate environment, they are more likely to approve applications.
3. Decrease savings
Since savings accounts will hold a negative interest rate, saving is discouraged since it will be costly to do so. Rather than hoard money, it should be put to use.
4. Increase spending
Transitioning from the point above, the hope is that businesses and individuals will save less money and inject that money into the economy through spending.
5. Increase investment
In addition to spending, investments would hopefully increase due to the relaxed credit environment.
6. Combat deflation
Negative interest rates are seen as a way to help weaken a country’s currency by making it a less attractive investment than other currencies in the world. If currency weakens, exports for that country become cheaper, and inflation can rise due to increasing import costs.
The items above should, in theory, battle deflationary periods, increase demand, and overall, get the economy moving again. It is a last-ditch effort once the central bank’s exhausted all other available means.
Potential Consequences of NIRP
Below are potential consequences of a negative interest rate environment:
1. Bank run
There are fears that negative interest rates would spur bank customers to rush to their bank and withdraw all their funds. Since they would be charged to save money, they would be left with no reason to keep funds in the bank, which would decimate the banking system. In the few instances that a NIRP’s been implemented, a bank run’s failed to materialize.
2. Hoarding of money
If businesses and individuals are penalized for saving, it is not guaranteed that they would take their money and spend it or invest it. They might very well hold onto that cash and hoard it. With fear in an economy, households might believe the best option at the moment is to sit on their cash until times are better. It would result in less economic activity than the NIRP intended for.
3. Bank profitability drops
When banks bear the costs of negative interest rates, rather than passing it through onto their customers, their profitability takes a hit and reduces its capital base. When it happens, they may not be willing to lend as freely. Instead of the intended purpose of stimulating lending, a negative interest rate policy could do the opposite.
4. Money market fund disruption
If interest rates went negative, money market fund yields could go negative as well. The money market fund industry is a major player in the financial system of the United States. Negative interest rates can cause major disruption.
While negative interest rates sound impossible or simply backward, they have been used before, and there are valid arguments for why the policy could work. The NIRP has only been implemented a handful of times, so the sample size to judge the positive effects is small.
Although negative interest rates also come with several potential consequences, we have not seen them materialize to a considerable level. A negative interest rate policy is not the first monetary policy tool of choice but is typically chosen once all other options have been exhausted.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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