What are Negative Interest Rates?
A negative interest rate by definition is an interest rate that is set lower than zero percent.
It connotes a situation where depositors are charged for cash deposits in banks as opposed to earning income in the form of interest.
It is assumed that they are being charged for storage. The negative interest rate is an unconventional rate which is set by commercial banks and the central bank in instances when lowering it up to the zero mark proves to be ineffective in influencing lending and borrowing.
Conventionally, interest rates have always been assumed to be bounded by the zero percent limit. However, in recent times, central banks have seen it necessary to assign them a negative value in a bid to stimulate economic growth.
How Are Negative Interest Rates Created?
Central banks do this through instituting an expansionary monetary policy which is referred to as the Negative Interest Rate Policy (NIRP).
A typical negative interest rate can be set at say, 0.3% implying that for every deposit, there is an accruing charge of 0.3% on the value of the deposit. In the long run, your principal deposit will reduce in value.
Therefore, you are better off engaging in capital spending or consumer spending or loaning out your money, instead of storing it in a bank. This is because this kind of loss is guaranteed, and you’d be better off setting measures to prevent this loss hence forming the impetus of negative interest rates.
Nothing New About Negative Interest Rates
Even so, negative interest rates are not quite a new phenomenon. They have actually been present though people have not been keen on them. This is true when you analyze nominal interest rates with respect to the level of inflation at specific times.
Consider an example: Having in mind that real interest rate is calculated as the difference between nominal interest rate and the level of inflation.
Let’s say nominal interest rate at a particular given time is 2% per annum, while inflation is at 3% per annum, the resulting real interest rate would be -1%. This is an interest rate that has a negative value. Therefore, negative interest rates have been present, in a way.
Impact of Interest Rate Policies
The impact of negative interest rate policies is felt especially by financial organizations in the banking sector. For most financial institutions, there’s always a set inter-bank lending rate. This rate represents the rate at which they will charge each other when they turn to the central bank for short-term reserves.
Most banks turn to the central bank to look for short-term reserves in the event that they have excess reserves. Thus, the central bank imposes a negative interest charge which will apply to a specified portion of funds that exceeds a certain threshold.
This is done so as to encourage the commercial banks to invest excess reserves rather than storing them.
Deflation Can Occur
The need to institute negative interest rate policies can be alluded to hoarding tendencies of individuals, businesses, and financial institutions when the supply of money in the economy has decreased.
This situation is referred to as deflation. When the amount of money is reduced, the resultant effect is the fall of prices of goods, services, and labor in the economy. Why the price drops? This is because deflation brings about uncertainty.
Thus, individuals and businesses are more inclined to save during deflationary periods, resulting in a surge in cash savings. A rise in cash savings automatically results in less consumer spending leading to the fall of demand for commodities and subsequently the fall of their prices.
Fall of prices would inevitably result in decreased production which on the other hand will lead to decreased output. Decreased production and output will collectively affect labor in terms of increased unemployment.
All these have an adverse effect on the economy and thus the negative interest rate policy is what is employed to act as a corrective measure.
What is the Point to Negative Interest Rates?
In essence, it can be deduced that negative interest rate policies have the overall aim of giving a disincentive to individuals, businesses, and financial institutions from hoarding tendencies.
Thus, banks and other financial institutions will as a result increase borrowing, lending, and even investments.
Depositors would see it as more beneficial and objective to use their money in investments, lending and other forms of spending as opposed to losing a significant part of it over time while keeping it.