Why would any economy want to have a negative interest rate???
Early 2016, when the Bank of Japan adopted negative interest rate to stimulate economic growth and raise inflation, the entire global market was shocked. So, was I. In the first look, this move appeared counter-intuitive.
But history speaks otherwise. This is not the first time negative interest rate monetary policy was employed.
In early 1970's, the Swiss government used negative interest rates to curb its currency appreciation. Post the subprime crisis, this tool was again used by Sweden and Denmark to increase aggregate demand of the economy. In 2014, the European Central Bank (ECB) applied negative interest rate on bank deposits to deter the savers, put the money in circulation and come out of a deflationary spiral. In March 2016, ECB had started charging 0.4% to commercial banks for keeping their cash overnight. In fact, the current fed interest rate is as low as 0.5% and there are market speculations that it might go negative depending on current global economy.
Before evaluating the negative interest rate monetary policy and how it would impact the economy, let’s try to understand key concepts behind this logic and why it is counter-intuitive to many economists around the world.
What is zero lower bound?
As the term explains, zero lower bound is when short term nominal interest rate is at or near zero.
But Central banks usually employ negative real interest rate?
This is different from real interest rate going negative, which means nominal interest rate is above zero but less than inflation rate. (Real interest rate = Nominal Interest rate – Inflation rate). Central banks usually employ negative real interest rate to spur economic growth. But zero lower bound is unusual.
Why is zero lower bound unusual?
At zero lower bound, central bank tries to increase market liquidity by buying securities. But banks did not want to lend and households did not want to borrow because they fear adverse effects of recession. This can cause liquidity trap where money supply fails to transcend to increase in aggregate demand.
What is negative nominal interest rate?
Nominal interest rate is set below zero lower bound i.e. negative. This policy is employed by the central bank to tax excess reserves held by commercial banks, with the intention to force commercial banks to reduce their excess cash reserve, thereby increasing their lending and providing liquidity in the market.
Point to be noted: This does not mean that commercial bank lending rate will be negative. Negative nominal interest rate might lower lending rate increasing the consumer's propensity to borrow and increase aggregate demand.
What is the Central bank’s rationale to deploy negative nominal interest rate?
Post the subprime crisis, most of the developed countries are facing the problem of falling aggregate demand, increase in marginal propensity to save and reduction in investment in general. As the excess deposits of commercial banks with central bank are taxed, banks will lower lending interest rate to give out more loans. This will increase the investment spending and in turn increase the aggregate demand by multiplier effect raising inflation to the desirable target in the process.
Why does it sound counter-intuitive to economists round the world?
There can be many undesirable impacts of negative interest rate.
Impact on Commercial banks: As the interest rate margin goes down, banks are under pressure to lend to make them profitable. This can lead to another housing bubble, trapped in the vicious cycle of recession.
Reduction in government bond yield: In June 2016, yield on 10 years, the German government bond has slipped below zero. In fact, yield across the world has been shrinking, fuelling negative market sentiments as investment in government bonds are considered to be safe.
Impact on Investment and household: The entire negative nominal interest rate is targeted to increase the investment. But investment is a factor of rate of interest and expected rate of return. With profit expectations going down as aggregate demand is all-time low, there are evidences that this policy has not fuelled more lending in Eurozone or Japan. In fact, sale of cash safes have increased in Japan as household are losing confidence in banking system to protect their hard-earned money.
Even though, economic growth for Eurozone has increased to >2% from 0.9% last year but critics contribute the growth to increase in salary rather than the negative interest rate. There is no strong evidence to support either the proponents or the opponents claim.
But as we know that investment cannot be increased just by reducing interest rate without increasing rate of expected return, it is high time for the Government to step in. A strong fiscal policy should be formulated targeting towards deflationary spiral - spend more in infrastructure and improve trade policies. These will lead to crowding in of private investments as expected rate of return rises, improving economic growth of the country and stabilizing global economy in longer run.
About the Author:
Pamela Ghosh is a IIM Calcutta PGPEX-10th batch student with 7 years of work-experience in IT products domain with companies such as Amdocs and Oracle. She has been married to Shishir kumar who is a fellow student of PGPEX-10th batch and has 8 years of work-experience in IT products domain with Amdocs, IBM ISL and Oracle.