The Negative Interest Rate: A Venture into Uncertainty

Bank of Japan

On Jan. 29, the Bank of Japan (BOJ) announced that, effective February 16, it will be adopting a negative interest rate policy, bringing down the interest rate to -0.1 percent. This move puts Japan in a group alongside the European Central Bank (ECB), Denmark, Sweden, and Switzerland — all of whom have implemented negative interest rates in order to stimulate their economies. According to Bloomberg View, even Federal Reserve Chair, Janet Yellen, has said the U.S. might consider a negative interest rate in the face of another economic downturn. With this venture into effectively unexplored territory in monetary policy, a significant percentage of world economies need the answer to the question: can negative interest rates stimulate our economies and what will be the costs?

The negative interest rate these countries are implementing is for a very specific type of account: the interest rate on accounts held by commercial banks with the nationally-run central banks. The move to negative interest rates means that commercial banks now must pay for central bank deposits rather than earn interest on these deposits. The central argument for negative interest rates is that they encourage commercial banks to lend more to customers. Logically, increases in lending should then stimulate growth within the economy.

This line of reasoning is not without its flaws. The possibility also exists that squeezing commercial bank profits will actually incentivize them to take even less risk through lending. According to a report by the Bank of International Settlements, banks in Switzerland have responded to negative interest rates by increasing their rates on mortgages. These incentives are explored by another analysis performed by Sweden’s central bank on the impact of negative interest rates. According to this report, Sweden experienced a decrease in lending but not of deposit rates below zero within commercial banks due to the lowering of interest rates. The paper attributes this to the commercial banks’ reluctance to charge their customers for saving and possibly lose them, which would lead to situations in which banks have difficulty lending money without losing out on profitability. The paper continues to argue that pushing interest rates further down would prompt banks to make deposit rates negative to stay profitable. This sets lower bound of monetary policy by making cash a significant alternative.

Another point of contention is the effect that negative interest rates would have on global financial markets, especially in surrounding countries with comparatively higher interest rates. Lower interest rates could lead to significant capital outflows to surrounding countries with higher interest rates, which creates a host of other problems such as making exports more expensive and creating bubbles. Capital outflows also open up the possibility of sudden flow reversals when the original economies begin to improve.

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Currency pegs cause even more complications. By adopting currency pegs, countries give up monetary policy as a tool to influence their economy. A significant change in monetary policy calls into question whether or not other countries will stay on their pegs, causing more volatility in exchange rates as well as the financial market as a whole. A clear example of this problem is the yen’s current effect on China. According to the New York Times, the People’s Bank of China has been experiencing major problems with capital outflows due to the devaluation of the renminbi, and, since the renminbi has moved to a peg consisting of a group of currencies — the primary one being the yen — a devaluation of the yen could exacerbate China’s depreciation woes. Japan’s influence on China’s peg reveals the underlying problem of the negative interest rate for foreign exchange.

The 21st century has ushered in “currency wars” such as the one observed between China and Japan. With an almost completely integrated global market, sudden changes in fiscal and monetary policies – while crucial in creating growth and helping economies – now have spillover effects into other countries. According to Lucy Meakin of Bloomberg View, the post-financial crisis global economy experienced a currency war in which countries competitively devalued their currencies in order to increase their exports to boost their economies. Practically, this war was a race to the bottom. Without clear communication and unity among central banks, changes in policies will almost always result in sudden capital flows and market instability. The post-financial crisis race to the bottom slowed down because countries agreed upon zero as the absolute minimum for interest rates. The recent shifts toward negative interest rates could start the next set of competitive devaluations to destabilize the world economy.

Negative interest rates are seen as a last resort indicating absolute desperation. As Sweden central bank’s analysis points out, there is a very clear lower bound for negative interest rates: when real interest rates fall below zero (in which case our financial systems should theoretically no longer function). While negative interest rates may stimulate the economy in the short run, the risks in the long run are enormous. A simple litmus test should be applied — if negative interest rates aren’t stimulating growth, then, in order to avoid a recession, the only way to go is down. As the Swedish central bank’s analysis shows, going down becomes less and less effective, and, at the bottom, substantial changes will be set in motion.