VRGK Financial Products Distributor Private Limite

02/11/2019

Negative Interest Rates

Imagine a bank that pays negative interest. In this upside-down world, savers are penalized and borrowers get paid to borrow money. Crazy as it sounds, the 2008 financial crisis created a lingering economic slump that drove the European Central Bank to experiment by cutting benchmark lending rates below zero in 2014. Then Japan followed. Some 500 million people in a quarter of the world’s economies ended up living with rates in the red. The idea is to jolt lending, spur inflation and reinvigorate economic growth by pushing through the floor after other options are exhausted. Half a decade later, what once seemed unorthodox has become entrenched and hard to shake. The new era of negative rates is now the subject of a debate about whether the policy has distorted financial markets, crippled banks and threatened pensions.

The Situation

Faced with renewed signs of economic weakness, the ECB pushed its benchmark interest rate further below zero in September 2019, charging banks 0.5 percent to hold their cash. Sweden, Switzerland and Denmark have also stuck with rates in the red, as has Japan. Acknowledging that negative rates have hurt banks, the ECB introduced a “tiering” system to partly shield a portion of their reserves; a program that in effect pays banks to borrow from the central bank was also renewed. Most lenders were initially reluctant to charge customers for fear they’d trigger mass withdrawals; when those fears proved unfounded, more banks introduced fees. Because central bank rates provide a benchmark for all borrowing costs across an economy, the policy spilled over into a range of fixed-income securities, including government debt and a handful of corporate bonds. That means investors buying those securities won’t get all of their money back. By mid-2019, the pile of negative-yielding bonds topped $17 trillion, or a quarter of all investment-grade debt, increasing the focus on how citizens are hurt when their retirement savings fail to grow. U.S. President Donald Trump has complained that the Federal Reserve has avoided negative rates. The disparity in rates between the U.S. and much of the rest of the world has drawn investment toward dollar-denominated assets, driving the value of the currency up and potentially hurting U.S. exports.

The Background

Negative interest rates were seen as an experimental measure after traditional policy options proved ineffective in reviving economies damaged by the 2008 financial crisis and recession. In the euro zone in particular, countries grappled with a shortage of credit and unemployment that only slowly receded from its highest level since the currency bloc was formed in 1999. The idea behind negative rates is simple: While positive interest rates represent the reward investors earn by risking their money by lending, negative rates punish banks that are playing it safe by hoarding cash. The goal was to ward off the threat of deflation, or a spiral of falling prices that could have deepened economic distress. While negative interest rates drove down what banks earned on money they lent, they still by and large had to pay customers for their deposits. The resulting squeeze on profits left many European banks complaining that the ECB was making it harder for them to lend, not easier.

The Argument

Some policy makers have repeatedly warned that ultra-low rates encourage “bubbles” in asset prices and risky lending. If more and more central banks use negative rates as a stimulus tool, the policy might ultimately lead to a currency war of competitive devaluations. There’s also a growing backlash about the impact on savers and concern about how that could taint the public’s view of the central bank. To many critics, though, the policy has simply run out of steam and may prove difficult to reverse. The Bank for International Settlements, a study group for central banks, warned in a September 2019 briefing that there’s “something vaguely troubling when the unthinkable becomes routine.” Policy makers who’ve turned to negative rates say they’ve helped their economies and that the downside — so far at least — has been manageable. They also point to a lack of other options: With many governments refusing to boost their economies through more government spending, they say, they need to use every tool they’ve got.