Some Countries Have Turned to Negative Interest Rates—Are They Crazy?

August 10, 2021August 17, 2021 Chuckles Freely 1 Comment economics, federal reserve, interest rates, society

Earning negative interest on savings sounds strange, if not impossible, but some countries have adopted this idea as a last resort to stimulate their economies.

After the 2008 financial crisis, central banks around the world slashed interest rates in an effort to boost their floundering economies. However, in 2012, with the crisis spreading, Japan, Denmark, Sweden, Switzerland, and countries in the eurozone turned to a more drastic, untested measure: dropping the central bank deposit rate below 0.

How is this possible? How can someone pay negative interest? It’s a bewildering idea, but it seems to be paying off. In March of 2021, the International Monetary Fund (IMF) released an analysis of the academic literature on this economic experiment’s impact. They looked at an array of indicators, such as money market rates, exchange rates, bank profits, among many others, and they found that negative interest rates appear to be a viable tool for boosting an economy.

What Is a Negative Interest Rate?

Central banks function largely like a bank for banks. That is, commercial banks can borrow and deposit money with their country’s central bank in much the same way that you or I can at our local branch. When they deposit money, they earn interest, and when they borrow money, they pay higher interest, with the difference between the two being the central bank’s profit.

Central banks help regulate the economy by tweaking their deposit and lending rates. When they raise rates, borrowing money from them becomes less attractive and saving it with them becomes more attractive. When this happens, commercial banks will likely deposit more money, spend less, and tweak their own rates for consumers to reflect the central bank’s rates. The average consumer will, therefore, be more incentivized to save and not borrow money. Theoretically, with less money in circulation, inflation will drop, keeping prices under control and economic output will decline. But when a central bank lowers interest rates, it becomes more attractive for commercial banks to borrow money, not deposit it, and to lower their own rates for consumers. With more money being circulated, inflation should go up, causing prices to increase and economic output will follow suit.

Graph showing the US Effective Federal Funds Rate — The Effect Federal Fund Rate is the interest rate that banks borrow and lend cash reserves to one another. Along with tweaking their own deposit and lending rates, central banks use it to regulate the economy. As can be seen in the graph, the rate was cut sharply in the aftermath of the 2008 financial crisis (Image Credit: Public Domain).

The central bank rate is supposed to have a powerful effect on the economy, although the 2008 financial crisis demonstrated its weaknesses. When mortgage default rates began to soar and wild mismanagement and greed became apparent, confidence in the economy ground to a halt. Spending and investment dropped severely, as people and companies preferred to save their were money due to uncertainty. To stimulate the circulation of money again, central banks dropped their rates. Then they dropped them again and again because the effect of doing so was far less than what was hoped for. Some central banks responded by lowering the deposit rate below zero, meaning commercial banks were charged for deposits. In other words, commercial banks were highly incentivized to use their money, instead of saving it with the central bank, as it would cost them more to do so.

Being charged for saving money seems like a weird idea, but nearly a decades worth of evidence shows that it may not be so crazy.

Did Negative Interest Rates Work?

All in all, the IMF believes negative interest rates have benefited the economies of countries using them, although this comes with some drawbacks.

Bank Behavior: The obvious first concern is how commercial banks responded. When it came to deposit rates, the IMF found that banks responded similarly to a reduction of positive interest rates, in that they lowered their rates to reflect the central bank’s. In particular, they raised fees on retail and business deposits and lowered their rates for short- and long-term investments. While this is expected under normal conditions, economists were unsure how banks would respond once rates dropped below zero. Therefore, negative interest rates seem to have been passed to both consumers and businesses as hoped for, meaning saving was discouraged and more money was circulating.

When it came to lending, commercial banks also lowered their rates. The IMF found that floating mortgage rates, for example, dropped substantially after negative interest rates fell below zero, and that “new corporate lending rates in the euro area dropped sharply after the ECB cut the deposit facility rate (DFR) into negative territory.” They also found the amount of lending increased somewhat, although not for every country. So again, when a central bank reduces interest rates, even into the negative, the effect is largely the same, in that borrowing money becomes more attractive.

Graph showing the decline of mortgage rates in Europe. — Mortgage rates in Europe have been on a steady decline largely due to interest rate cuts from the European Central Bank. Negative interest rates starting in 2012 seem to have the same effect as any other rate reduction (Image Credit: Euro Area Statistics).

And large banks seem to have figured out how to cope, in that their profits remained steady. The IMF found that negative interest rates “only had a small overall effect on profitability because losses in interest income were offset by gains in non‐interest income, such as fees, capital gains, and insurance income.” Therefore, large bank viability didn’t deteriorate, as some economists feared. Rather, they seem to have responded in much the same way as any other rate reduction. However, the same cannot be said for small banks because they are “not engaged in cross-border lending, face significant competition, are real estate and mortgage specialists, or operate in countries where floating loan rates predominate.” In other words, staying profitable with negative interest rates takes flexibility, creativity, and market influence, which small banks lack.

Financial Markets: How did negative interest rates affect government bonds, money markets, exchange rates, and stock markets? Government bonds are issued and sold by governments to help fund expenditures, and the value of a bond increases in value at a specified interest rate, which depends on the time before it matures and supply/demand. When a central bank lowers rates, rates for government bonds generally go down, as non-government investments tend to become more attractive and vice versa. The IMF found that “Once rates are negative, the impact of interest rate cuts on the yield curve appears to be similar to interest rate cuts in positive territory.” This shows that in this case negative interest rates didn’t produce radical, unpredictable effects.

Furthermore, money markets offer consumers a relatively low-risk, low-reward, highly-liquid place to park excess cash, as they invest largely in secure assets like short-term government bonds. When a central bank lowers interest rates, investors generally look for longer-term, higher-paying investments, making short-term bonds unattractive and driving down their rates. Therefore, money market rates are correlated with central bank rates, and when central bank rates went below zero, money market rates followed. In all countries studied by the IMF, the introduction of negative interest rates immediately led to negative money market rates.

And what about exchange rates and stock markets? The IMF doesn’t know. The academic literature on the subjects is mixed, as there are an array of studies showing both positive and negative results from the implementation of negative interest rates, while some researchers believe there were no effects and others believe the effects were too short-lived to measure properly. The IMF stated that exchange rates and stock markets are influenced by far too many factors to analyze properly.

Economic Output and Inflation: The ultimate goals of negative interest rates, as is any central bank rate reduction, is to boost economic output and manage the inflation rate. The IMF found that they are “comparable to those of conventional policy rate cuts and quantitative easing, but the effects on inflation may have been modest.” That is, a rate reduction into the negative has the same effect as normal rate reductions when it comes to output, but the effect on inflation was not as pronounced.

Graph of eurozone negative interest rates. — The inflation rate for the eurozone was only moderately affected by the introduction of negative interest rates circa 2012 (Image Credit: World Bank).

Conclusion

Although it’s uncharted waters, the data from the eurozone, Japan, Switzerland, Sweden, and Denmark suggests negative interest rates don’t produce economic anomalies and are a viable tool for managing the economy. All in all, it seems a rate reduction is a rate reduction, regardless of it being above or below zero, right?

Not everyone agrees, though. US economists are highly skeptical of using them to tweak the US economy:

James Bullard, head of the St. Louis Fed, said in May 24, 2021 “You’ve got Japan and Europe mired in negative interest rates. We’d rather stay out of that game.”
John Williams, President of the New York Fed, said “Negative rates I think have a worse cost-benefit relationship than the other tools that we have.”
Jerome Powell, head of the Federal Open Market Committee, said in May 2020 “The committee’s view on negative rates really has not changed. This is not something we’re looking at.”
Solita Marcellit, Chief investment Officer for UBS, said in July 2021 “Implementing a negative interest rate policy in the U.S. would be too much of a disruptor (not the same issue overseas).”

It’s difficult to say whether or not this sentiment will continue, as central banks are increasingly turning to new tools to meet new challenges. For example, the European Central Bank is considering the coronabond. Like other bonds, the coronabond is meant to fill funding gaps, but this bond is designed to raise funds specifically for non-government expenditures related to battling the coronavirus. Another example is the introduction of Quantitative Easing in 2008 to provide relief from the financial crisis. Therefore, central banks are not adverse to adopting new methods of managing economies. Given the IMF data above, it could only be a matter of time before negative attitudes towards negative interest rates becomes a thing of the past, despite how counterintuitive the idea might seem.

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