NEGATIVE INTEREST RATE: THE NEW NORMAL
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.http://www.almconsultingltd.com