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Negative Interest Rate Environment

When the central bank of a specific economic zone sets the nominal interest rate to zero

What is a Negative Interest Rate Environment?

A negative interest rate environment occurs when the central bank of a specific economic zone sets the nominal interest rate to zero. Such a move, in effect, makes banks charge money to deposit holders (individuals and businesses) to hold their funds. The charge occurs instead of the regular interest that is accrued when money is deposited into such instruments like a savings account.

 

Negative Interest Rate Environment

 

Negative interest rates are generally introduced in times of great economic peril, and they function as a method of stimulating the economy when many other measures become ineffective. It should theoretically help to spur investment and consumer spending, thereby stimulating the economy. Its introduction is sparsely seen and not without significant drawbacks and criticisms.

 

Summary

  • Negative interest rates occur when interest is charged on cash deposits rather than given to account holders.
  • Such types of interest rates are rarely introduced, as the tactic is often met with opposition and criticism. They also run the risk of introducing panic into the financial markets.
  • Negative interest rates would theoretically be introduced in times of great economic peril to rescue or stimulate the economy.

 

Negative Interest Rates – A Recessionary Growth Tactic

In times of recession, different central banks will often put forth the idea of introducing negative interest rates as one method of stimulating economic growth. When deposit-taking institutions are forced to pay negative interest rates on their holdings, it acts as a sort of penalty to the banks, seeing their balance sheets shrink on the cash deposits they hold. Theoretically, if it were to happen, banks would be motivated to lend out their cash reserves. It can be completed in the form of credit to large and small businesses, as well as individuals.

Such a tactic is intended to help create new businesses that, in turn, create new jobs that help to bring the economy back into a recovery position. It is also completed to sustain borrowers’ financial stability to help avoid layoffs and ensure a stronger financial position for the borrowing company.

The figure below provides different tools that have often been floated by economists and how they can be part of a three-pronged strategy to spur economic growth:

 

The Jury is Still Out – Questions Around Negative Interest Rates

Negative interest rates are often seen as an extreme measure and are not widely used even in times of great economic peril; however, they’ve been used in other capacities to varying degrees of success.

In Japan, negative interest rates were introduced in 2016. The Japanese economy’s long been in a state of stagflation, with little to no substantial growth compared to other developed nations globally. While the economy in Japan is seeing some stability nowadays, it still endures smaller growth numbers – particularly surrounding GDP – than its developed counterparts.

 

The Unknowns – Risks with Negative Interest Rates

The introduction of negative interest rates runs the risk of introducing panic into the financial markets. Individuals may become worried that their savings will become swallowed up by the government and that they are being punished for keeping savings accounts.

Whether such fears are founded or not, there exists a psychological component to negative interest rates that prevents them from ever fully being adopted or realized – like in the Global Financial Crisis of 2008. The US Federal Reserve often analyzes introducing such a radical measure, but falls short and does not wish to introduce it into the market.

 

More Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Cash Reserves
  • Expansionary Monetary Policy
  • Federal Reserve (The Fed)
  • Quantitative Easing

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!