Can you imagine a day where you are paid when you borrow money from banks?
It seems unrealistic at the first point, but this is what happens when any country breaks the zero-level barrier on base rate and go negative.
2020 has been the year of rate cuts. Most of the central banks have witnessed the rate cuts than they would have ever in this decade. This year is driven by unprecedented events. It has made unthinkable a routine now. An unconventional move like a negative interest rate seems like a viable option now to most of the central banks to stimulate economic growth. Let’s find out what implications does this tool has on the economy.
Negative Interest Rate: A Quantitative Easing tool
In the negative world, you will pay the bank to hold onto your cash assume it as storage cost. While when you go out to buy a car you will end up making some money. But how can interest rate turns negative? Isn’t zero the benchmark for all borrowing and lending activities. But it’s not impossible to attain. Several countries are already trapped in this negative zone.
During the negative interest rate scenario, the borrowers are credited rather than paying to lenders. This also implies that commercial banks are charged for keeping their deposits in central banks.
This happens when people hold too much money rather than spending. This results in a sharp decline in demand and prices fall down further. Well, the worst is not over yet. The sharp decline in demand slows down the economy resulting in unemployment.
Central Bank’s stance on interest rate is very critical because it shapes the economy. If the rates are too high, people would restrict themselves from borrowing and start saving more in their wallets. If it is too low, people would borrow more and spend more. Negative Interest rate is one such tool through which the central bank intervenes to encourage people to borrow more and spend more in order to boost the economy.
The interest rate which we usually come across is the nominal interest rate. The percentage increase in money which you pay to the lender for the money you borrowed. It does not take inflation into account. However, the real interest rate reflects the purchasing power of money, which the lender receives when the borrower pays him back the borrowed money with interest.
Nominal Interest Rate = Real Interest Rate + Inflation
If the inflation is higher than the nominal interest rate the real rate turns negative, which effectively means that the value of your savings falls. You would be able to buy less from the money you saved. This induces people to cut down on their savings and start spending more.
The negative interest rate is the last resort for most central banks. It is used when everything else is falling apart and nothing much is working in favor of the economy.
Behind the walls of Bank of England:
The walls of BOE have never experienced a negative interest rate in its 325-year history. The UK has cut its interest rate from 0.75% in March to 0.25% and now it is currently at 0.1% level. At such a level, it is very hard to make any difference between negative and positive interest rates. This happens when you cut interest rates so much that there is no maneuver to accommodate more fluctuations.
This tool came to the table when the Government sold a bond with a negative yield. This means that if investors hold the debt until it matures, they would be paid back less than they would have paid for it.Those countries who have witnessed negative yield are already awarded negative interest rates from their central banks. This clearly sends out a signal that the Governor is taking negative rates into consideration. Governor Bailey told lawmakers that BoE was not ruling out taking rates below zero for the first time, it was “not ruling it in” either. So far they have been reluctant to adopt this measure because it could cause damage to the capital base of banks. But given the crisis are so deep and prolonged, the Bank of England won’t hesitate to jump the ladder and cross zero marks.
Negative territory countries:
1. The World’s oldest central bank Riksbank of Sweden took a drastic step to reduce its base rate to -0.10% in 2009.
2. Following it was Denmark who decides to cut its policy rate to zero in the year 2012.
3. European Central bank in 2014 adopted for negative interest rate regime in order to address the eurozone crisis. It’s base rate went down to -0.5% lowest amongst all.
4. In order to fight against deflation, Japan entered the negative zone and its key rate has been negative since 2016.
Although their economic results have not been very spectacular and this is still used on an experimental basis. It has prevented many countries from the deflation spiral, but these timid cuts were not enough to boost the economy. Though this medicine works, it has not been able to cure the problem on a large scale.
Consequences of negative rate cuts:
1. The central bank could restrict the commercial banks to park their money, but they can’t force them on lending. Because the rates can be lowered, but the risk still prevails in the system which further deters banks from lending. Hence the purpose of creating a demand in the economy is not served well by negative rate zones.
2. Depositors would prefer keeping their money under the mattress where they could earn a 0% interest rate rather than negative rates. And when all the people take out the money simultaneously, it could create a situation of Bank Run.
3. Negative interest rates weaken the country’s currency, making it a less attractive option for investment as compared to other countries. It gives exporters a competitive advantage, but an increase in import cost leads to a rise in inflation.
4. This also means a reduction in the Net Interest Margin of banks, which they gain from their lending business.
In theory, negative Interest rates seem attractive in the short run. It should stimulate economic activity and avert inflation, but no central bank wants to continue with it in the long run. Analysts are still cautious in using this because there are several ways in which this unconventional policy could backfire. But once you are in, it’s difficult to move out. It should not be used unless absolutely necessary.
Whether Bank Of England adopts it or not, let’s just hope it sets aside all the aspects of nations’ pride and focus on real-world consequences and how to combat them. At this point in time, Britain needs all the support from its central bank to get back on track.