What are negative interest rates and who uses them?

ECB
By Andrew Harbison, CA Today

14 February 2017

Last August there was much speculation about how far the Bank of England (BoE) would cut interest rates. Some commentators reported the possibility of the base rate being brought to zero, with the potential of it being knocked into negative figures.

As appears to be the trend these days, the predictions were wrong. The BoE decided to cut interest rates in half, from 0.5% to 0.25%, in an attempt to meet the 2% inflation target and “sustain growth and employment”.

However, the practice of cutting nominal interest rates below zero is not uncommon. While a weaker pound and inflation showing signs of moving higher may mean the UK has seen a bottom in rates, elsewhere in the world, the context of historically low economic growth rates mean that negative rates are becoming a reality.

But what are the implications of adopting this kind of monetary policy, who is doing it and what are the pros and cons?

What are negative interest rates?

It is important to establish that, at the time of writing this article, negative interest rates have only been adopted by central banks.

It was previously thought that rates would never drop below the zero lower bound (ZLB). The ZLB just that, a 0% interest rate. Negative, it now seems, is the new ZLB.

When central banks apply negative interest rates it means they charge commercial banks to hold their money. The theory behind this is to make the prospect of holding back money unappealing for commercial banks and to encourage individuals and businesses to borrow more money in the hope of giving the economy a boost.

Who has used them?

Switzerland began operating negative interest rates in order to control the flow of foreign investment into the country as this was making the Swiss franc soar. Sweden and Denmark have also adopted the policy.

The European Central Bank (ECB) and most recently Japan are operating at minus rates.

Around a quarter of the global economy has now adopted a negative interest rate policy, something which Big Four firm PwC calls “historically unprecedented”.

What are the advantages?

Stopping commercial banks stockpiling money and increasing lending are two reasons behind negative rates.

In terms of the overall economy, the negative rates could encourage consumers to spend more. The theory behind this is that people are more likely to spend money on goods and services than pay a fee to the bank for holding their money for them.

Investing may also receive a boost as companies are more likely to borrow and invest larger sums of money. If this investment is in areas such as manufacturing this could lead to job creation, lowering the rate of unemployment.

For central banks aiming to boost the economy through a rise in exports, negative rates are one solution. As seen in the Swiss example, setting rates below zero will lead to a devaluation of currency, which should in turn increase exports from the region.

What are the disadvantages?

The most obvious downside is if banks choose to pass on the cost of negative rates directly to private savers.

As mentioned before, the idea of negative rates is to stop money being hoarded, but it may encourage that type of behaviour.

Since the introduction of negative rates, sales of safes have dramatically increased in Japan as people take their money out of the banks to avoid paying the bank charges.

Luke Hickmore, portfolio manager at Aberdeen Asset Management, also pointed out a rise in safe sales in Europe in an interview with Business Insider last year.

Although devaluing currency to increase exports is an advantage, this method has its dangers. By lowering the value of currency, the central bank could set off a chain reaction with trading partners racing to the bottom, effectively starting a trade war.

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  • Business

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