So what is a negative interest rate?

January 29, 2016

What is a negative interest rate?

  • Commercial banks normally earn interest when they deposit money with a central bank, such as the U.S. Federal Reserve, instead of putting it into circulation in the economy in the form of a loan. 
  • But when a central bank imposes a negative interest rate, it costs a commercial bank to park its money there. 

Central bank interest rates

 

Why would a central bank make interest rates negative?

  • It’s a rarely used tool of monetary policy, but a central bank uses negative interest rates when it wants to stimulate more lending by commercial banks.
  • When banks are forced to lend more rather than depositing their excess cash at a central bank, they inject more money into the real economy.
  • This can help beat back deflation – an environment in which consumers defer spending on the expectation that prices will be lower in the future, hurting demand for goods and services, and therefore economic growth. 
  • Negative interest rates are seen as a last resort when a central bank has already reduced benchmark lending rates to close to zero to stimulate the economy. When near-zero rates aren’t enough to convince banks to lend, negative interest can be the next incentive.

 

Japan inflation

 

Why did the Bank of Japan turn to negative interest rates?

  • While the Bank of Japan only decided to move to negative interest by a narrow 5-4 vote, BOJ Governor Haruhiko Kuroda defended the decision by pointing to falling oil prices, China and market instability as signs that the global economy was slowing and that Japan faced deflationary pressure.
  • The BOJ governor told a news conference that the central bank would do whatever it takes to achieve inflation at 2 percent. Read the central bank’s release here:

 

 

So what happens now?

  • In currency markets the yen tumbled. This is exactly what the BoJ was hoping for because it means cheaper Japanese goods and services on the world stage – and therefore another boost to their economy.   
  • Commentators have also pointed out that despite the BOJ’s insistence that it will do anything to get to 2 percent inflation, there is a limit to how negative interest rates can go before prompting investors to hoard their money under the mattress.
  • The BoJ move also makes it harder for the U.S. Federal Reserve to raise its interest rates four times this year, as it forecasted when it increased interest rates for the first time since December 2008. The Fed, which raised rates from zero on the argument that the U.S. economy was growing stronger, may now feel the effects of a global slowdown. 

 

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