At the recently concluded Economic Symposium organized by US Fed at Jackson Hole, Wyoming involving leading central bankers and economists from around the world, there was a growing clamor for more radical measures to fuel growth and inflation. The chief among them being negative interest rates being used in Japan & Europe to stimulate anemic growth.
First, let’s understand how negative interest rates work. There is a lot of confusion on how they function, as in do the lenders have to send a coupon payment? So going to the basics first: A simple zero coupon bond if brought for $1020 today redeemed for $1000 one year hence, gives you a negative yield of -2%. Or even if coupon payments are included, for instance your bond also paid a $10 coupon at year end, still it would have given a negative yield of -1%. So, effectively the Present Value of all future payments result in a negative yield.
The case for negative interest rates: At present as much as $10 trillion of sovereign debt around the world bears negative interest rates. Economists argue that just as gold standard and fixed foreign exchange regimes were abandoned to unencumbered price fluctuations and global demand & supply, the time has now come to let go the zero bound on interest rates to freely accommodate inter-temporal price movements and employment. Further, immobilizing the interest rates at zero, compels amplification of economic stimulus through the fiscal route which involves risk taking on behalf of tax payers, credit risk assumption and problems in credit allocation. Negative interest policy is least market intrusive, is reasonably free of political color and highly flexible.
Logic Defies Negative Interest Rates: If the commercial banks decide to pass on the negative interest rates to their depositors, the depositors may simply withdraw their funds and it might create run on the banks thus endangering the whole banking system. Further, if banks continue to absorb the effect of negative interest rates for a longer period of time, it may seriously impact their profitability. Bank for International Settlements has warned in March 2016 that if more & more banks around the world adopt this policy, it might lead to greater uncertainty which may ultimately result in a currency war of competitive devaluation.
Drawing a Line in Sand: Clearly the concept of Negative interest rates is a radical concept and has gained currency during the prolonged anemic recovery period post 2008. It is said desperate times call for desperate measure and hence the negative interest rates. But what is more fundamental here is the limits of the monetary policy. Is the monetary policy, as a fundamental driver and an external stimulus capable of reviving the economy under any condition? The experiment in negative interest rates will let us know about the elusive line in sand where the monetary policy stops.
About the Author:
Aman Jindal, a Financial Economics enthusiast, is a FRM Part-II & CFA Level-I cleared student at IIM Kozhikode. An avid reader of English Classics, he loves having conversations on topics ranging from philosophy to politics.