What is a negative interest rate policy (NIRP)?
A negative interest rate policy (NIRP) is an unorthodox monetary policy applied by a central bank of a country, setting nominal interest rates with a negative value below zero percent.
Examples of countries and regions where NIRP are employed
The Swiss National Bank was the first central bank to use negative interest rates in the early 1970s to counter the appreciation of the Swiss franc, which was viewed as a safe-haven by foreign investors.
The Danish central bank of Denmark has applied negative rates since 2012, partly to keep the Danish krone aligned to the euro.
Japan has its front-end rates at minus 0.1 percent since early 2016.
The European Central Bank (ECB) introduced a negative interest rate in 2014 that is only applicable to its deposit facility (the rate banks receive for overnight deposits). The rate is -0.50% since September 2019.
When would a central bank apply NIRP?
NIRP is a relatively new strategy in monetary policy used to reduce the impact of a financial crisis.
Basically, NIRP is applied when every other type of traditional macroeconomic policy has proved ineffective to mitigate a dwindling economy.
In a weakening economy, prices of goods and services gradually decline due to, inter alia, a reduction in the money supply and a decrease in the availability of credit. This leads to a declining inflation, eventually reaching a negative figure which is called deflation.
Deflation motivates people to hold onto their money, calculating they can buy relatively more with their cash in the future than at present. This behaviour has negative feedback loops that can cause economic depression.
Typically, a central bank will fight a declining inflation and threatening deflation and stimulate the economy by gradually lowering the official interest rate of the country until it reaches the zero lower bound (ZLB) when the price of money is zero.
When deflation (negative inflation) is still imminent, a central bank can resort to a policy of a negative interest rate as a last-ditch effort to boost economic growth.
Put differently, NIRP is employed by central banks to counter deflation, attacking it before it becomes entrenched in an economy. If not reversed, deflation can turn into a dreadful economic circle that can be extremely difficult to break.
How does NIRP work?
Simply put, by employing a negative interest rate policy a central bank has two objectives:
- To make it more costly to keep money at a bank or financial institution.
So, instead of receiving interest on any deposits, investors and other people or entities with money at the bank would have to pay a ‘fee’ to keep their money stored at the bank.
Hence, people are basically discouraged to hoard cash and are coerced to spend their money.
- To make it attractive and beneficial to borrow money.
The purpose is to encourage banks to lend money more easily.
Imagine, instead of paying the bank to borrow money, the bank is paying you to borrow its money!
The dominating intent is to increase overall economic activity instead of remaining stagnant. People are encouraged to spend their money, putting money back into the economy, hopefully in the more productive parts of the economy.
By spending more, people would help to stimulate the economy.
Example of how NIRP would affect an individual:
- Let us say a person puts R10 000 into a bank deposit account at a 3% interest rate per annum. At the end of that year, the initial deposit will be worth R10 300, including R300 (3% x R10 000) interest for the year.
- The same person deposits R10 000 into a bank deposit account at a negative interest rate of 3% per annum. At the end of the specific year, the investment will be worth only R9 700.
Risks involved in NIRP
Although a countermeasure to mitigate the impact of a fledging economy, there are numerous risks involved when a central bank applies NIRP.
- In a way, conventional savers are diddled out of a potential income source.
- By completely destroying the income of savers, the economy is deprived of a key income stream.
- Negative interest rates force lenders, such as banks, to broaden their base of borrowers in order to generate more fees to compensate for the negative effects of NIRP. Lenders have to lend vast sums to marginal borrowers – borrowers who would not qualify for loans in more normal times.
This compels lenders to either go without the income from lending or take on significant risks in lending to marginal borrowers.
- Investors and fund managers are pushed by NIRP to become yield chasers, i.e. to invest in securities only because they offer high yields. However, higher yields are a direct consequence of higher risk. This could eventually lead to considerable losses because high-risk investments always involve the possibility of losses.
- Negative interest rates mean that businesses and individuals pay to keep their money in banks. However, it is also applicable to commercial banks keeping their money at the central bank of the particular country.
- One unpremeditated consequence of NIRP is that banks may decide to keep their money ‘in-bank’ instead of lending it out. Commercial banks could absorb the interest costs instead of passing them on to outsiders.
This would happen if the banks fear that demand will exceed their supply of cash.
Such a strategy would be counterintuitive to one of the goals of NIRP, banks lending more money allows businesses and individuals to spend more.
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