Stuffing Mattresses: The Rise of Negative Interest Rates Part I

In the last year and a half, central banks around the world have experimented with lowering deposit interest rates below 0%. Earlier this year, the Bank of Japan became the 5th central bank to adopt a negative deposit interest rate, the rate at which central banks pay commercial banks for deposits. A negative interest rate effectively forces commercial banks to pay central banks for any excess money deposited in a central bank. The Bank of Canada has recently announced that it would be willing to introduce a negative interest rate in times of economic crisis, indicating that the trend towards negative interest rates is not slowing down.

It isn’t difficult to see why negative interest rates have become so popular. Sluggish growth has plagued the EU’s recovery from recession and Japan has faced sluggish growth for much of the past two decades. Negative interest rates help to combat that by encouraging commercial banks to lend money, and in doing so, lower the interest rates for consumers to increase the amount of borrowing. The increased borrowing that comes as a consequence of lower interest rates goes back into the economy through increased spending, ultimately increasing the aggregate demand within a country, stimulating the economy, and accelerating economic growth.

Many economists believed that negative interest rates would never work. It was widely believed that a negative interest rate would simply lead to banks holding money in cash. Empirical evidence in the EU has disproven that theory; commercial banks have not yet withdrawn money from central banks to hold it as cash. The transaction fees that are associated with commercial banks counting, storing, moving, and insuring large quantities of cash would lead to higher expenses than simply paying the European Central Bank for depositing their money. Consequently, commercial banks have continued to hold their money in the ECB.

However, that poses a different problem. Most commercial banks have not lowered interest rates for consumer deposits in fear that such actions would reduce their ability to compete with other banks. The decreased profit margins that come from negative interest rates reduces the amount of money that commercial banks have which may cause commercial banks to lend less money than before. That jeopardizes the potential effectiveness of negative interest rates.

Although it is up for debate about whether or not negative interest rates will increase lending by commercial banks, there is some consensus that negative interest rates should decrease the exchange rate of a currency. Sweden, Denmark, and Switzerland all have adopted negative interest rates as a way of depreciating their currency through deterring the purchase of their currencies.

As these effects all converge, some economists are worried that business conventions will drastically change as a result of negative interest rates. As The Economist notes, “[c]ompanies would seek to make payments quickly and receive them slowly [and] [t]heir inventories would grow fatter.” Any type of pre-paid card could be used as zero-yielding assets as an alternative for depositors.

Although the economic theory for negative interest rates has been comprehensively developed, predictions have failed to identify the effects of negative interest rates thus far.

By,

Jason Xiao

Works Cited

http://business.financialpost.com/news/economy/canada-could-adopt-negative-interest-rates-within-the-next-two-years-citi-says

http://www.theglobeandmail.com/report-on-business/economy/what-are-negative-interest-rates-and-how-do-they-work/article27669897/

http://www.economist.com/news/finance-and-economics/21679231-central-banks-are-still-testing-limits-how-low-interest-rates-can-go-bankers

http://www.economist.com/news/finance-and-economics/21679231-central-banks-are-still-testing-limits-how-low-interest-rates-can-go-bankers

Picture taken by Carsten Frenzl accessed through Creative Commons at the following link.