Negative interest rates: what do they mean?

A summary of negative interest rates

• Typically employed as a last resort when faced with deflationary pressure or a very weak growth of the economy
• A monetary policy tool designed to penalize savings and holding of cash and incentive banks to loan out cash 
• Commercial or retail banks would be charged for holding their cash with the central bank 
• Some economists argue that negative interest rates are a unsustainable tool and can cause detriment to the economy if used over the long term
• Can sometimes be effective in preventing deflation within an economy and get back to more healthy economic environment such as the case with Sweden 

Introducing negative interest rates

With interest rates at an all time low this places a lot of pressure on retail and commercial banks to make money through the net interest margin - but with the global economy as it is with many economies reporting significant contractions in GDP terms could economies go further down the line to utilization of negative interest rates?

Amid the coronavirus pandemic the UK and USA (Trump going insofar as to call negative interest rates a 'gift') have both mentioned the possibility of negative interest rates as a potential weapon in the arsenal to combat the economic fallout arising out of the pandemic. As of March 2020 Switzerland reported a benchmark of a three month LIBOR of -0.75 whilst Denmark had reported a certificates of deposit rate of -0.60% and the Bank of Japan had an unchanged interest rate of -0.1%. So negative interest rates are hardly anything new, but as the UK had never used these before what exactly does this mean? 

Understanding negative interest rates: for the economy

This policy is concurrent during deflationary periods or very weak economic growth. Deflation deters investment as it signals a decrease in demand for products but possible expansion of supply. In the worst case, this could indicate a deflationary spiral in which this signals a very undesirable economic environment where the price level falls in response to a contraction in aggregated demand, restricted production, lower wages which can result in a downward spiral resulting in even lower prices, production and great deflation. 

By utilizing negative interest rates this penalizes holding onto cash and can act as an incentive to invest, spend and hopefully boost the economy to growth. This can also impact on foreign exchange as by utilizing negative interest rates it is likely that investors will move their investments elsewhere where the interest rate paid on deposits is higher. This could result in depreciation of a currency which could potentially make the countries exports more competitive on a pecuniary basis.

Regardless of the cons and pros negative interest rates are generally seen to be a unsustainable tool as prolonged use of this could result in an economy facing detrimental consequences. This is because prolonged use can impact on consumer and investor confidence as it signals curtailed growth resulting in contractions of foreign direct investment.

Understanding negative interest rates: for financial markets

As mentioned, a negative interest rate would typically result in the foreign exchange of that economy contracting significantly. This would weaken the value of that currency on the forex market. 

Whilst this might bear good news for traders who hold short positions in this currency on the forex market it could be of detriment to traders or investors who are long in this currency. 

Understanding negative interest rates: for shares

Typically a contraction in interest rates will always result in a depression in the net interest margin which is a bank primary means of making money. Naturally a negative interest rate could experience reduced demand for their shares. 

However others sectors, such as manufacturing, could enjoy a boost from investors as the increased liquidity often bares fruit for other sectors. Moreover, if the negative interest rates are maintained for a significant period of time this could help them become more internationally competitive in pecuniary factors. This can be considered below in Japan's example.

Understanding negative interest rates: for banks

Negative interest rates occur when borrowers are credited interest rather than paying interest to lenders, in other words lenders will charge you interest to keep cash with them rather than paying you interest. This of course will reduce the incentive to hold onto cash and possibly push for investments in other financial instruments or boost consumption spending. 

 This is a monetary policy tool designed to incentivise banks to make loans during a period in which they would rather hold onto cash. This are typically utilized of critical efforts to boost economic growth through financial means.

So, if a bank is charged for depositing surplus cash outside the regulatory requirement then this means the bank would rather 'store' their money with individuals and businesses at a abysmal rate as this would reduce the charge (assuming this meets the risk criteria). This of course depressed the rate on their loans. This will leads to increased borrowing this theoretically could catalyse greater spending and economic expansion. 

For individual borrowers, for example mortgages it would be important to look at the fine print - Nationwide building society, for example, will never reduce the rate it tracks below 0% on mortgages arranged since 2009 – so if your mortgage is at base rate plus 1 percentage point, it will never fall below 1%. Santander specifies in some mortgages that the lowest rate it will ever charge is 0.0001%.

 

However, that being said last year Danish bank Jyske bank released the world's first negative interest rate mortgage. Those who took out a loan with Jyske Bank were lent at a rate of -0.5% meaning the sum owed fell each month by more than the sum they repaid. 

Examples of negative interest rates:

Japan

Japan is primarily an economy that is fueled by its exports. It is commonly ascertained to be an export-orientated economy. In March 2016 the Bank of Japan decided to counteract its strengthening Yen and deflation of the economy by introducing negative interest rates. 

This made the Yen a less attractive investment compared to other currencies on the market - especially those that are typically paired with the Yen such as the AUD/JPY or USD/JPY pair. 

Since the implementation of loose monetary policy in 2012 the Japanese economy has grown perhaps this can be partly attributed to the negative interest rate set by the BoJ. 

Switzerland

Switzerland has one of the lowest interest rates in the world set at 3m LIBOR or -0.75% for commercial banks who store their cash with the central bank. In 2018 it was calculated that Swiss commercial banks had paid c. £1.6 billion in negative interest charges. 

It is crucial to note however the Swiss National Bank only charges negative interest on deposits that are above a certain exemption threshold. This was designed to alleviate some of the pressures associated with negative interest rates on the regional commercial and regional Swiss banks.