Central banks across the world have been talking about it, some have already implemented it, and others are still considering it. It is safe to stay that Negative Interest Rate Policy or NIRP could pretty much be the new norm, right after QE. A decade ago, negative interest rates were seemingly unthinkable, but in today’s times where central banks mandated to maintain price stability or inflation, negative interest rates are mentioned periodically and with ease. So what are negative interest rates and why is there so much fuss around this?
What is Negative Interest Rate Policy?
In a sane world, interest rate is the price one pays to borrow money. In the credit markets or bond markets, it goes by the name of yield. Yield is nothing but a dividend, interest or returns an investor expects from a security or a bond or simply cash that you want to lend. Therefore, a 2.0% interest rate simply refers to $2 interest the borrower must pay for borrowing the amount of $100. To be more precise, a 2.0% annualized interest rate means that at the end of the year the borrower is expected pay the $100 and an additional $2 in interest. Now imagine a -2.0% interest rate. In this scenario, the borrower will have to pay only $98 on the $100 that was borrowed.
Interest rates as a monetary policy tool
Interest rates are primarily used as a tool to tighten or ease the supply or money or in other words, interest rates are used for managing the money flow into the economy. When interest rates are low, the logic is that consumers are encouraged to borrow which in turn is expected to spur lending. Likewise, when interest rates are high, loans or borrowing money is more difficult, thus resulting in less spending.
Interest rates are generally used a mechanism to control inflation, which most central banks are mandated to maintain.
Commercial banks generally earn interest by parking their excess reserves at the central bank. This interest rate can vary but is usually close to the main lending rates (Ex: 0.25% – 0.50% at the Federal Reserve, or 2.0% at the Reserve Bank of Australia).
How negative interest rates work?
It should be obvious by now how the negative interest rate policy works at the central bank level. Negative interest rate, often considered drastic is a tool to discourage commercial banks from parking their money and instead increase lending to its customers. Therefore, under negative interest rates, commercial banks end up paying the central bank the interest rather than the other way around.
Negative interest rates came about and gained traction more importantly after the 2008 global financial crisis. With inflation failing to rise and growth stalling, central banks were caught in a corner. Even the introduction of bond purchases or Quantitative Easing failed to help revive the growth that was expected. So, in a way, one could argue that negative interest rates are the next step in a central bank’s monetary policy toolkit, used for the purpose of encouraging lending and increasing money supply. As you might know, inflation is nothing the availability of money. The more money there is to go around, the higher the prices will be.
Which central banks are using negative interest rates?
Negative interest rates are widely in use in Europe. The central banks currently using negative interest rates include:
- Danmarks Nationalbank or Danish National Bank: The Danish National bank does not have an inflation mandate but instead has the goal to keep the DKK steady. Danish National Bank started implementing negative interest rates since mid-2012 and its interest rate is currently at -0.65%
- European Central Bank: The ECB cut its main bid rate to zero percent, but its deposit rate facility was cut to -0.40%
- Swedish Riksbank: The Swedish Central Bank cut the interest rate to -0.50% in February of 2016 in an effort to battle inflation
- Bank of Japan: The Bank of Japan surprised the markets in January 2016 by bringing down the interest rates from zero percent to -0.10%
- Swiss National Bank: The SNB cut interest rates to negative in January 2015, sharply from zero percent to -0.75%