Will Negative Interest Rates Work?

Central bankers’ monetary toolkits have been exhausted, so they are looking for new ways to stimulate demand.

Keynes’ liquidity trap has prevented many central banks from implementing negative interest rate policy (NIRP). With interest rates so low and demand so dry in today’s modern economic environment, the once potent monetary policy is now becoming infertile. As interest rates approach zero, there is less scope for them to be lowered further, so policymakers are looking for new ways to stimulate demand. One way to do this is to set rates below zero, which in nominal terms has not been used until the 21st century. The ECB and Japan have attempted to offset tighter fiscal policy, spurred by fears of rising national debts, by pioneering NIRP. Though, other economies are reluctant to do so. The case for negative interest rates is complex.

Bank profitability

Firstly, NIRP affects bank profitability. Commercial banks run a spread business, whereby they profit on the difference between the return on their assets (loans) and interest payments on their liabilities (deposits). However, they are reluctant or unable to charge negative rates on deposits when interest rates fall below zero. Hence, their spread narrows and profitability diminishes, which worries economists as struggling banks are unlikely to keep lending. Thus the overall effect of NIRP may restrict bank lending channels.

Despite this, this concept does not consider the effect of NIRP on banking activity. Negative interest rates encourage borrowing, meaning banks are likely to see a rise in the demand for loans when consumers decide to buy a house or finance a car. Thus, the increased volume may offset narrower profit margins. Additionally, aggregate economic activity is likely to rise, and this can feedback into the banking sector. Finally, long-term interest rates will almost certainly remain positive since consumers pay a duration premium for borrowing money over a long-time horizon. Hence, though the spread may narrow, it is unlikely to reverse.

To conclude, though NIRP is likely to reduce bank profitability, this can be somewhat offset by an increase in economic activity and thus a rise in demand for bank loans. Hence over the short term, this is unlikely to have scarring effects on the banking sector.

The liquidity trap

Secondly, NIRP may be diluted by the liquidity trap. John Maynard Keynes argues that liquidity preference may become virtually obsolete beyond a certain level of interest. Negative interest rates effectively subsidise hard cash, as paper currency is restrained to a zero nominal return, whereas bank deposits can go negative. Hence, households switch to cash in search of higher returns. This hoarding of cash is contractionary for the economy as it is not spent, so demand is suppressed.

Despite this, this theory assumes that the demand for cash is infinitely elastic; there will be infinite demand for cash when rates drop below zero. In practice, this is not the case for several reasons. Initially, consumers are not wholly irrational and are thus unlikely to check the rate their bank accounts pay frequently. Additionally, and more importantly, holding cash comes with various financial and risk-associated costs. Households may incur withdrawal fees at ATMs or their local bank, and then storing cash in vaults or safe spaces can also be costly. Risk factors associated with holding physical currency at home include theft, natural disasters, displacement, or damage. Hence, the net return on paper currency is likely to be negative.

To conclude, while liquidity preferences are present in society, they may not be as prevalent as classical economists may assume. Humans are not perfectly rational while holding banknotes comes with some apparent costs. Interest rates thus have leeway into negative territory — the more significant the burden of holding banknotes, the further they can go.

Allocation of resources

Finally, NIRP can lead to inefficient resource allocation over the long run. Negative interest rates decrease the cost of borrowing significantly, meaning investors have access to cheap money and can invest in more risky assets. This inflates asset prices, not only due to the ready availability of credit but the meagre returns on short-term securities. It props up financial markets, and capital flows into them increase. Over time, this can skew the composition of an economy favouring the financial sector while creating the risk of an asset bubble. Hence, NIRP can risk financial instability.

To combat this, NIRP must be implemented in short sharp intervals. The reversal rate, the rate at which loosening monetary policy becomes contractionary for lending since bank profits fall, falls over time. Consequently, ‘low for long’ is unfavourable, whereas implementing negative rates for short periods to ignite demand can be a successful policy decision. Though, when the time comes for central banks to tighten monetary policy, they must do so with transparency and forewarning, else they risk a situation like the 2013 taper tantrum or the 2007–8 global financial crash.

To conclude, low for long NIRP can damage the composition of the economy and skew capital allocation, favouring the finance sector. Setting negative rates for short periods can be an effective tool to battle depressions, so long as the recovery in rates is timely and approached with great care.

Conclusion

To conclude, NIRP faces a trade-off between stimulating aggregate demand while disrupting lending channels by weakening bank profitability and risking cash liquidation. Consumers and businesses that are not confident in the economy’s future will avoid spending and will save for tomorrow. Lowering rates further is unlikely to make them budge. Forward guidance is likely to have a more beneficial effect in this situation, as trust and confidence in the central bank can go a long way.

Hence, NIRP must only be used when the banking sector is robust and other monetary measures fail to work.

If you enjoyed this article please👏 (up to 50 times) or if you have any feedback feel free to comment below!

Ted Jeffery

--

--

--

A student passionate about economics and how the world works. New blog post every Monday.

Love podcasts or audiobooks? Learn on the go with our new app.

Recommended from Medium

Q1 2019 bank results session is over: did we learn anything new?

Is the expansion in US labor supply pulling down wages?

Chicago’s future ADU ordinance should learn from other cities’ mistakes

Economic history after market-metaphysics

Oil stages 12% rebound rally after sharpest decline, When Will It Hit a Bottom?

The Analysis of Forex Market(19th May 2020)

How Traditional Banking Fails Customers Of Color And What We Can Do About It

What’s Going on in the Repo Market?

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
Ted Jeffery

Ted Jeffery

A student passionate about economics and how the world works. New blog post every Monday.

More from Medium

Growth Hacking applied to War Situation

Will Inflation Bring Another Arab Spring in 2022

Will unexpected spikes in fertilizer break Egypt’s ability to subsidize basic food costs in Egypt?

Agro Kings Goes “Green” With Gasor Electric

Build Your Own DIY Electric Truck