Negative nominal interest rates

             NEGATIVE NOMINAL INTEREST RATES

Since the great recession a large number of advanced economies have been stuck in low growth, low investment (government, GFCF) and low inflation which in turn lead to unemployment. Attempting to regain growth, the central banks have increasingly taken forceful monetory policy measure and most criticised and lesser known amongst them are negative interest rates.

The central bank of Denmark was the first to go below zero in 2012 and surprised many that this negative interest rate policy did not put pressure on financial system. After this a series of negative interest rate policies followed i.e. from U.S. FED, Bank of England, and Bank of Japan.

Interest rate below zero is often viewed as unconventional policy, but it is actually the continuation of normal monitory policy practise of moving short-term interest rates in response to fluctuations in economy. It is obvious that there is a limit as to how much negative the interest rates can go, but as of now it’s been to -.75% in Switzerland.  The working of negative interest rates is as same as positive rate hikes or lows, though there are some differences in their effects on banks, and the psychological impacts on plunging interest rates into negative territory.

HOW DO INTEREST RATE CUTS BELOW ZERO WORK?

Commercial banks park their money in central banks and if the interest rate goes into negative zone then central banks charge for the interest on commercial banks money. The commercial banks can cut the interest rate that they charge their customers by the same amount and make their money back, although there are some crucial exceptions for some bank deposits such as retail deposits. Imagine a pension fund, who has invested in the commercial banks, if the risk free rate is charged or lower down, then they would invest in financial assets like the bonds ( which are like long term loans), increases demand for financial assets, hence the price for the bond shoots up and this is how rate cut is transmitted to broader financial market.


These summaries the aim of central bank that is to reignite growth in the country, consumer spending, rise in demand which in turn rises inflation, rate cutes from banks transferred on to companies, increases the money supply hence rises the supply of goods & services, which in turn helps in reducing unemployment. These are the few ways where this can happen
1- Fall in demand for currency, hence the value of currency depreciates, which fuels export and reduction in import
2- Consumer spending more
3- Business investing more
4- Banks lend more to households and companies as holding cash has become costlier now

The flipside of the above mentioned ways:
1- Currency depreciates, hurts the margin, which was clearly visible in Japan as some of the exporters showed unhappiness as the razor thin margin was already eroded and coupled with weak demand in advanced economies such as Europe, U.S. and weakness in China dimmed the advantage of weakening of currency
2- Countries whose demography showed aging population, incentives to spend more will fall on deaf ears. Faced with negative interest rates, savers and retired people would be seen spending less and save more, which lowers down the velocity of money, could likely to reduce the spending because they either have fixed deposits or because they live on interest on capital.
3- As the spending power or people go into saving mode, the velocity of money is fractured, which in turn leads to business investing less in meeting the demand.
4- With the weakening of economy and central banks not making holding cash as costly as it had to be, banks turn reluctant to pass on the advantage as it happened in India: as the repo rate was reduced by 25bps, banks never passed on to customers, as the deposit rates were too high and they could not lower it down because of competition.

REAL VERSUS NOMINAL INTEREST RATES:

Negative nominal interest rates coupled with higher inflation, leads to lower real interest rates, which lowers down the value of money and purchase power parity (PPP). Countries where the inflation is higher than the nominal interest rates, real interest rates are negative and savings fall in value. In countries where inflation is lower than the nominal interest rates, real interest rates becomes positive which in turn increases the value of savings.

In U.S. today, short-term real interest rates are negative, because inflation is in positive trend, but nominal interest rates are still negative. If you have a savings or bond denominated in dollars it is losing value as we speak.

Switzerland on the other hand, inflation is negative and nominal interest rates are negative too, and two largely cancel out each other. In Switzerland the saving or bonds are losing value at a lesser rate than in US

The danger of negative rates and the most important concern is about at what point the retail investors, financial corporations will want to sell all bonds to get the cash. The lower bound is not known. Other risk is long period real interest rates, rather than negative nominal interest rates, might lead to financial instability and investors might look out for other options to invest because of low returns on bonds and some financial institutions are also charging a fee for holding cash. This is what the definition of monitory policy: stimulate risk-taking and economy. But if the investment goes into real estate whose prices rises in time, creating a bubble, which might burst one day, like the one in China right now.

SO WHAT IS THE RIGHT TIME TO RAISE RATES?

Increasing the nominal interest rates before the economy has returned to growth, risks delaying the return to growth. Hence we see the Federal Reserve delaying the rates hike in U.S. One of the risks being the Trump victory has caused a cloud of uncertainty. Second the U.S. is so big that most part of the currency traded in the world is dollar denominated and raising the rates cannot be done without considering the world’s economic shape

SO IS THE NEGATIVE INTEREST RATES ONLY WAY OUT?

Monetary policy is not the only strategy to stimulate the economy. Government spending on infrastructure, tax cuts to boost export, running deficit accounts would boost the economy by generating employment, and increasing the spending power.