Back to Basics: What Are Negative Interest Rates?
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Bibliographic details
- Authors: VIKRAM HAKSAR, Emanuel Kopp
- Published: March 1, 2020
How negative interest rates arise and how they are defined
- Nominal interest rates are "stated rates that borrowers pay on a loan."
- Real interest rate = nominal rate minus rate of inflation.
- Example preserved from source: "When inflation is 3 percent, and the interest rate on a loan is 2 percent, the lender’s return after inflation is less than zero."
- Negative nominal policy rates: central banks "make banks pay to park their excess cash at the central bank."
- Economic intuition: negative interest rates give consumers and businesses an incentive to spend or invest rather than leave money in bank accounts whose value would be eroded by inflation.
Why central banks have experimented with negative rates
- Objective: "encourage banks to lend out those funds" and thereby counter "weak growth that persisted after the 2008 global financial crisis."
- Central banks experimenting with negative rates include: "the European Central Bank and the central banks of Denmark, Japan, Sweden, and Switzerland."
- Negative policy rates are one option when conventional policy rates hit the zero lower bound; "monetary policy affects an economy through similar mechanics both above and below zero."
The role of the policy rate and the neutral interest rate
- Policy interest rate: "the key benchmark for borrowing costs in the country’s economy."
- Higher policy rates → incentives for saving; lower rates → motivate consumption and reduce cost of business investment.
- Neutral rate definition: "the long-term interest rate that is consistent with stable inflation. The neutral interest rate neither stimulates nor restrains economic growth."
- When policy rates are lower than the neutral rate, monetary policy is "expansionary"; when higher, it is "contractionary."
Drivers of the long-term decline in the neutral rate (as presented)
- The neutral interest rate "has been on a clear downward trend for decades and is probably lower than previously assumed."
- Possible drivers cited:
- "long-term demographic trends (especially the aging societies in advanced economies)"
- "weak productivity growth"
- "the shortage of safe assets"
- "persistently low inflation in advanced economies" that has "lowered markets’ long-term inflation expectations"
- Consequence preserved: "not only have long-term interest rates fallen, but in many countries, they are now negative."
Main concerns and risks of negative interest rates
- Bank profitability:
- Banks earn a spread = difference between what they pay depositors and what they charge on loans.
- Lowering policy rates tends to reduce this spread as "overall lending and longer-term interest rates tend to fall."
- If banks avoid passing negative rates to depositors, "this could in principle turn the lending spread negative" and "lower bank profitability and undermine financial system stability."
- Cash substitution:
- Negative rates on deposits could incentivize savers to "switch out of deposits into holding cash."
- Cash's face value cannot be reduced, so "there has been a concern that negative rates could reach a tipping point beyond which savers would flood out of banks and park their money in cash outside the banking system."
- Uncertainty: "We don’t know for sure where such an effective lower bound on interest rates is."
- Operational mitigants and limits:
- "Banks can charge other fees to recoup costs."
- In practice, "rates have not gotten negative enough for banks to try to pass on negative rates to small depositors (larger depositors have accepted some negative rates for the convenience of holding money in banks)."
- The existence of cash as an alternative remains a limiting factor on how negative policy rates can go.
Practical implications and concluding points
- Low neutral rates imply short-term rates could more frequently hit the zero lower bound and "remain there for extended periods of time."
- As a result, central banks "may increasingly need to resort to what were previously thought of as unconventional policies, including negative policy interest rates."
- Summary definition reiterated: "Simply put, interest is the cost of credit or the cost of money. It is the amount a borrower agrees to pay to compensate a lender for using her money and to account for the associated risks."
VIKRAM HAKSAR is an assistant director in the IMF’s Monetary and Capital Markets Department. Emanuel Kopp a senior economist in the IMF’s Strategy, Policy, and Review Department.
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