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Negative Interest Rates - Can They Stimulate The Economy?

Negative Interest Rates - Can They Stimulate The Economy?

Nick Cawley, Senior Strategist


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Negative Interest Rates – Can They Stimulate The Economy?

What are Negative Interest Rates?

Negative interest rates mean that any money deposited with a bank incurs a charge, or cost, for the lender. When rates are positive, the lender receives interest on their money from the bank, when rates are negative, the lender pays the bank interest to hold their money.

Interest rates across the globe have been cut sharply in the last 3 months as governments and central banks try and stem the economic damage caused by the COVID-19 virus. With zero percent interest rates now commonplace, there has been further speculation that central banks may well have to push rates into negative territory, as well as employing other non-traditional monetary policy measures, in a fresh attempt to boost slumping growth and soaring unemployment.

Why do Central Banks Change Interest Rates?

Interest rates are used by central banks to control economic activity and inflation by increasing or lowering the cost of money. Central banks (CBs) use these rates to try and keep the economy running at an optimal level, neither too hot or too cold. If economic growth and inflation are running above the CBs mandate, they will raise interest rates to keep both in check, while if growth and inflation are running below target the CB will lower interest rates to boost both back towards target. If interest rates are low, the cost of borrowing for companies or consumers is lowered in an effort to push spending and increase the money supply in the economy, while raising interest rates is likely to crimp spending and decrease the amount of money flowing through the system.

With economies around the world crashing into recession, central banks need to keep increasing the flow of money through the economy.

Central Bank Intervention in the Foreign Exchange Market

Countries with Negative Interest Rates

Negative interest rates are rare but not new and they are currently used by three central banks in Switzerland (-0.75%), Denmark (-0.60%) and Japan (-0.10%), while the ECB deposit facility – the rate banks receive for overnight deposits – is -0.50%. In effect, it costs banks to deposit money with these central banks. To mitigate these negative costs, commercial banks will try and lend money with a small margin above the bank rate, to companies and consumers, negating the cost of leaving money with the central bank.

The Swiss National Bank first used negative rates all the way in the 1970s and their current NIRP policy is used to stem the appreciation of the safe-haven Swiss France, helping the countries exporters. The Danish central bank has used negative rates over the last eight years in part to keep the Danish Krone aligned to the Euro, while Japan introduced negative interest rates back in early 2016 to boost consumer spending as the country’s economy continued to stagnate. The European Central Bank first lowered its deposit rate into negative territory in 2014 to ease the single-currency lower and help Euro-Zone exporters become more competitive, after the single-blocs economy was roiled by the 2008 global financial crisis.

Central Bank Calendar – Interest Rates and Policy Meeting Dates

How Does Negative Interest Rate Policy (NIRP) Work?

Central banks around the globe are now mulling pushing interest rates into negative territory as economic data show the impact of the COVID-19 virus on the economy. Many CBs have already ramped up quantitative easing measures to unprecedented levels to provide liquidity and further QE may likely only produce marginal results as its effectiveness wanes. While CBs are talking about NIRP, it doesn’t automatically mean that they will take rates negative. A central bank’s remit is to be flexible and use all available monetary tools and recent CB talk is likely to be a reminder to markets of just this; that they stand ready and willing to use all options if needed.

NIRP policy is not an automatic panacea for failing markets and poses its own problems. The banking sector relies on positive interest rates to make a margin on their lending to customers and NIRP effectively cuts the bank margins to wafer-thin levels. In addition, while ultra-cheap money should see consumers spend more - boosting growth and inflation - if people are worried about their own jobs and their future finances they are likely to hold back on any additional spending, whatever interest rate is being offered.

How Effective are Negative Interest Rates at Stimulating Economies?

The jury is still out over the effectiveness of negative interest rates due in part to the use of other monetary policy tools currently employed. The massive quantitative easing programmes introduced by countries around the world have boosted market liquidity and increased global money supply and these programmes are expected to be ramped up further if inflation and growth refuse to pick-up. A loosening of fiscal policy is also expected to help economies pull back from the COVID-19 abyss, although the trajectory of any recovery is still one of the market’s great unknowns.

If central banks believe that taking interest rates into negative territory is warranted, it may well be a sign that other measures have not worked as expected, and that will send out a strong negative signal to financial markets over the near-term growth and inflation outlook. While other non-traditional policies, including quantitative easing, are traditionally used before pushing rates into negative territory, extreme times call for extreme measures.

Additional Reading:

US Recession Watch Overview – US Yield Curve Hides the Truth

The European Central Bank (ECB): A Forex Trader’s Guide

The Swiss National Bank (SNB): A Forex Trader’s Guide

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