When  you  lend  somebody  money,  they  usually have  to  pay  you  for  the  privilege.  That has been   a   bedrock   assumption   of   financial institutions   for   centuries.   But   this   is   an assumption that is increasingly being tossed aside by some of the world’s central banks and bond markets. In recent months a number of the world’s   central   banks   have   veered   into territory once unimaginable to most economists: negative interest rates. Investopedia says negative  interest  rate  policy  is  an unconventional  monetary  policy  tool  whereby nominal  target  interest  rates  are  set  with a negative  value,  below  the  theoretical  lower bound  of  zero  percent.  Standard  textbook theories  hold  that  negative  interest  rates  are infeasible  because  depositors  always  have  the outside  option  of  holding  onto  cash,  which  is storable   and   therefore   pays   an   effective interest rate of zero. During    deflationary periods, people and businesses tend to hoard money instead of spending and investing. The result is a collapse in aggregate demand which leads to prices falling even further.

A  downward  shift  in  aggregate demand  will  cause  a  slowdown  or  halt  in  real production  and  in  turn  affect  output  and increase  unemployment.   The typical macroeconomic  tool  utilized  by  the  government is  an  expansionary  monetary  policy  where  the central   bank   tries   to   encourage   economic growth  by  increasing  the  money  supply  in  the economy by lowering interest rates. However, if deflationary  forces  are  strong  enough,  simply cutting  interest  rates  to  zero  may  not  be sufficient to stimulate borrowing and lending. Setting  a  negative  interest  rate  means  the central  bank  will  charge  banks  interest  to  hold reserves  -  deposits  which  commercial  banks hold at central banks.  By lifting asset prices,   negative   interest   rates   may   raise expectations of improved economic conditions and thus higher future revenues from assets. By forcing   investors   away   from   safe   assets towards  riskier  ones,  negative  interest  rates encourage investors to shift out of government bonds  and  into  riskier  assets  like  the  equities market. By lowering the exchange rate, negative interest  rates  can  weaken  the  currency  vis-à-vis  its  trading  partners  which  can  boost exports and hence growth and employment, while lifting inflation through higher import prices.

Nevertheless, negative interest rates has its drawbacks.   It   encourages   governments   to borrow more.  And  if  government  borrowing becomes  free  lunch,  there  is  clear  disincentive for  fiscal  discipline.  Also,  there  are  risks  to negative  interest  rates  at  an  operational  level about  which  we  know  little.  While  charging commercial banks to hold reserves sounds simple in  theory,  in  practice,  implementing  negative interest     rates     requires     sophisticated management  of  an  increasingly complex  financial system.  Another drawback is given the tepid recovery and increasingly volatile global financial system; it is easy to sympathize with calls for ever   more   accommodative   monetary   policy. Negative   interest   rates   may   have   some stimulating effect, but also come with potentially significant downside risks.  While   negative   interest   rates   may   seem paradoxical, this apparent intuition has not kept a number of central banks (Danish National Bank, Swedish National Bank, Swiss National Bank, European Central Bank and Bank of Japan) from giving it a try.

This is no doubt evidence of the dire situation that policymakers find themselves. Many are still grappling with the notion of negative interest rates.  They  have  never  been seen until recently,  but who’ s to say that if deflation  does  materialize,  other  central  banks won’t join the bandwagon? It would be unusual and unconventional, but entirely appropriate if deflation was to emerge as a serious risk. You can click the link below t connect with us, or if you have any questions., thank you.


Popular posts from this blog