Understanding Negative Interest Rates

Negative interest rates have become a potent tool in the arsenal of economic policymakers. In recent times, most significantly, they have been deployed to solve economic fallouts from disasters such as the 2008 global financial crisis. From time to time, different parts of the world experience those disasters, with substantial economic impacts. The 2005 Hurricane Katrina, for example, is believed to have caused aggregate financial losses of over $200 billion.

Source: CGTN

Disasters, from natural to health, the increased productivity of exporters can offset it and closure of factories and loss of jobs. To manage them, favorable economic interventions may be needed. Notably, a usual way governments go about reversing financial woes that tend to come on the heels of disasters is lowering interest rates. 

Benefits of Low-Interest Rates

Far from negative interest rates, central banks can lower interest rates for many reasons. First, they can do so to stimulate loan demand. Generally, when the interest rate is lower, individuals and businesses alike tend to borrow more. And, when they do, spending on credit-sensitive products increases, investors reach for higher-yielding investment vehicles, the prices of assets are driven up, and wealth grows. In fact, the most common reason central banks lower interest policy rates is to stimulate economic activities via increased lending.

To enhance your adequate understanding of them, the economic benefits of lower interest rates can be more clearly highlighted as follows: 

  • Lowered interest rates help to lower the real cost of borrowing.
  • They spur businesses to spend on capital goods.
  • They also motivate households to spend more on consumer items.
  • Central banks use them to help banks recapitalize their books.
  • Lowered interest rates result in gains in asset prices.

However, a usual, though unintended side-effect of lower interest policy rates is the currency depreciation that follows. This effect makes imports more competitive but it can be offset by the increased productivity of exporters.   

Why Negative Interest Rates?

The decade after the 2007-2008 financial crisis saw tremendous global economic growth. Unemployment all over the world was at some of its lowest levels in many years until 2020 when COVID-19, the most impactful disease outbreak since the 1918 Spanish Flu, began. First identified in December 2019 in Wuhan in Hubei Province of China, it was eventually designated a pandemic on March 11, 2020, by the World Health Organisation (WHO). Multiple daily market crashes followed. March 12 and March 16, nicknamed “Black Thursday” and “Black Monday” respectively, had the most significant drops. In response, banks and reserves started lending support to investors.   

To deal with the risks the pandemic posed to economic activity, the Reserve Bank of Australia cut its rate by 25 basis points, bringing it to the lowest in the country’s history. In mid-2020, Switzerland targeted dropping its interest rate to -0.75%. Around the same time, Japan also adopted a target interest rate of -0.1%. A negative interest rate policy (NIRP) seeks to encourage banks to lend out money, since it will be expensive for them to hold it, to prevent another credit crisis. It also aims to reduce borrowing costs. With negative interest rates, central banks charge commercial banks for keeping cash with them.  

Since 2020, the Bank of England has been considering a negative interest rate to stimulate UK’s COVID-stricken economy – even though at 0.1%, it is already at one of its lowest levels in history. However, there are many parties that believe a negative interest rate will have only counterproductive effects. A negative interest rate would reduce the revenues of banks, which, scampering to protect their margins, may subsequently drive up mortgage costs. While a negative interest rate has an attractive, economy-boosting appeal, it portends many risks for regulatory fiscal policy and financial stability.

The information on this website and all associated literature are for educational and informational purposes. It does not constitute a fiduciary duty or obligation between Uncut Lab and you. Please consult your financial and investment professional for your specific situation.

author

Lucas

I am the Uncut Lab resident cloud computing junkie. I help curate the written content in our Education Corner, providing engaging articles on foundational concepts in cloud computing, data analytics, machine learning, and blockchain technology. Feel free to reach out to me with questions or topics that you would like us to cover. Thanks!

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