When banks can’t lend at higher interest rate and earn, they offer negative interest rate and pay individuals to borrow from them.
What does negative interest rate mean?
Negative Interest Rates is a situation where borrowers are credited interest instead of paying interest to lenders. This scenario mostly occurs during a deep economic recession when monetary policy and market forces have already pushed interest rates to their nominal zero bound which refers to the lowest level that interest rates can fall to. Logic dictates that zero would be that level. Also, during deflationary periods when people or institutions are inclined to hoard money, rather than spend or lend it.
Lender is paying the individual or business to borrow money from them, which means that borrowers get paid and savers are penalized. Banks usually benefit from negative interest rates as they can make loans during a period in which they would rather hand on to funds.
Negative interest rates implemented by countries
Amid challenging economic conditions in the pandemic, many economies have adjusted policies and interest rates for long term survival.
Denmark’s primary interest rate is the certificates of deposit rate set by its Central Bank which is currently at -0.60% a slight increase from the previous level of -0.75%. This is unlike other nations that have been relaxing monetary policy in response to the coronavirus. Inflation in 2019 was 1.3% and is expected to be 1.5% in 2020.
Spain’s interest rate is set by the European Union which is currently at 0% and is at the same rate for the past four years. 2019 inflation was at 0.68% while target for 2020 is at 1.05%.
Sweden benchmark interest rate stands at 0% in late 2019 compared to -0.25% ending its 5-year run of negative interest rates. Repo rate which is the main interest rate stood at 1.74% in 2019 and is expected to be 1.46% in 2020.
There are a few situations where negative rates have been implemented during normal times – as of mid-2019, Switzerland’s target interest rate was -0.75% while Japan’s mid-2019 target rate was of -0.1%. It is used by banks as a monetary policy tool which stimulates borrowing and lending. They have been unchanged in current scenarios also.
In order to mitigate the pandemic impact, Japan’s government said that it will increase its purchasing of riskier assets and corporate bonds. It is also offering loans against corporate debt as collateral with rates set at 0%.
Lowest interest rate after EUs rate is the United Kingdom, at 0.1%, followed by the U.S. at 0.25%.
Bank’s reaction on negative interest rate
Negative interest rate will generate more loans and higher economic growth is only a belief that does not prove to be correct because when economic situation is unattractive no consumers will take loans to buy cars or homes even if financing terms are feasible.
The inflation-adjusted rate of interest or the real rate is the number that investors care about since it is the nominal rate adjusted for changes in purchasing power, said Mike Davis, an economics professor at the Cox School of Business at Southern Methodist University in Dallas. If individuals earn a rate of 5% but prices go up by 3%, they have only earned 2%.
The real rate can be negative in situations where inflation is unexpected. When real rates are negative, the economic situation is either already bad or likely to deteriorate, he said.
“The negative rates may by psychologically jarring, but there’s nothing special about them. If rates change from 3% to 1%, they’ve fallen by 2%,” Davis said. “If rates change from 1% to -1%, they’ve also fallen by 2%.”
Negative Interest Rate Policy (NIRP)
NIRP is developed since the 1990s wherein it is used to partially balance the negative impact of the financial crisis and is officially brought into role under extraordinary economic circumstances.
An example of NIRP would be to set the key rate at -0.2%, such that bank depositors would have to pay two-tenths of a percent on their deposits instead of receiving any sort of positive interest.
Some risks and unseen circumstances of these policies would be that if banks penalize households for saving it may not lead to retail consumers spending more cash. On the other hand, they may accumulate cash at home in risk of negative interest rate.
However, banks can choose to apply the NIRP not to household savers but to the large balances held by pension funds, investment firms and other corporate clients. Thereby attracting corporate savers to invest in bonds and other vehicles that offer better returns while protecting the bank and the economy from the negative effects of a cash run.