In the environment where we see negative interest rates regime is being followed by many central banks, we wonder what exactly do negative interest rates mean? What is the objective of these policy measures? Are they effective? What are the implications? This article will try to evaluate the basics and then in subsequent articles we will touch upon some implications of this policy.
What do Negative Interest Rates Mean?
In layman’s terms it means that, if you keep money with the bank then you have to pay the bank for keeping your money. By virtue of this policy central banks want you to borrow money and spend it. This kind of policy is a part of monetary policy and relatively new concept which central banks are trying to put into practice.
The assumption here is that consumers and businesses would not want to lose money by keeping it in a bank, but rather they will either spend it or invest. With that, the economy will get a boost which is more rewarding in the longer term.
Does it work?
It sounds counter-intuitive, and against all principles of finance we have assumed and studied this far. Imagine a bank giving money to us to borrow money from it. So how is it expected to work in real life?
As of now there is no clear evidence that such monetary policy works. However, central banks are trying hard to make this work. It has certainly reduced the value of currencies in the economies where it has been applied which helped boost exports to an extent. But will it help in sustaining economic growth is yet to be seen.
The following are potential effects of this policy
- This policy has moved shorter term bond yields to negative. In this scenario, you may argue that why would an investor want to buy a negative yield bond. The answer lies in the speculative nature of investments. The Investor may expect increased demand for bonds, as the central bank may buy the bonds in future, which may increase the bond prices.
- This certainly raises question on viability of commercial banks, as they will lose money if the cost is not passed to consumers. If banks pass on negative interest rates, then they have a fear that they will lose the customer. It’s a net loss for bank in that case- since there will be excessive demand for borrowing money and less for depositing money
- Depreciation of Currency – This may increase the currency flow into the financial system and hence increase liquidity with currency depreciation.
- Significant negative impact on Pension Funds – As perceived by most of us – pension funds are relatively safe and are expected to earn a decent return over a period of 25-30 years. However, such a policy for a sustained period can impact both companies as well as investors negatively.
- Can increase risk taking of Retail Investors – Retail investors in the search for good returns which beat inflation and not averse to loss of capital can deploy good amount of money into risky assets which can increase market volatility.