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Rutgers Business School

Negative Interest Rate

KaWai, Tang

Global Money Market & Institution

Professor. James Winder

11/20/2016

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Negative Interest Rates

Introduction

Definition: Negative interest rate is just like any other ordinary interest rate, except that in this

case, the person who lends the money has to pay the person who borrows the money (Black 33).

In other words, it is like the reversal of the ordinary economic rules since the depositors will pay

money to save more of their money.

The depositors referred to, in this case, are the banks. When people open accounts in commercial

banks, the bankers often keep their money in Central Banks. Examples of central banks include

Bank of Japan, European Central Bank and the Federal Reserve (Samuelson 467). Central Banks

often get an interest when they keep their moneys in such Central Banks. However, in the case of

negative interest rates, the commercial banks are charged a fee by the Central Banks. The whole

point is to inspire the commercial banks to use their monies productively, for instance, lending

the monies to businessmen and other individuals. These negative interests will wave in the

economy by reducing the borrowing costs for every individual (Neumeyer 345). This is

something that economists argue heighten the economic development. An example of negative

interest is when the Central Banks decide to set the interest rate at -0.2 %. In such a case, the

bank depositors will pay 0.2 percent of their deposits to the central banks rather than receiving

the 0.2 percent from them, which is quite the opposite.

Involvement of the Central Banks

The Central Banks shrink the electronic money of commercial banks so that they may impose the

negative rate on commercial bank’s deposits. When these deposits read negative, the central

banks will eliminate the excess reserves because these must move to their deposits and then get

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shrunk (Merton 449). Commercial banks usually don’t lend extra reserves to their clients since

only organizations with reserve accounts are the ones that may hold reserves. Reserves are only

lent and borrowed amongst banks and no third party such as a client is involved. Banks may also

buy bonds, but such transactions only take place amongst the banks.

Why banks borrow reserves

Usually, banks require a limit of threshold for the reserves. These thresholds are often set by the

Central Banks. However, banks need reserves so that they can take care of all the transactions

that take place within their systems. When a client deposits some money to the banks, these

banks use the money as loans because such money is not always kept without any use (Mankiw

56). When the bank moves the money to another bank, say bank B, it merely moves its debt to

bank B. Therefore, it will have to compensate bank B for such an act. These compensations are

what are referred to as reserves.

The central banks are the ones responsible for creating the excess reserves. In most cases, banks

usually hold the reserves that they require and lend and borrow the same reserves amongst each

other (Shiller 1190). Central Banks often create extra reserves when they want to conduct an

emergency act. For instance, during the global crisis, the banks did not want to lend money to

each other, hence the European Central Bank permitted some banks to borrow money from the

central banks (Cox 406). When banks borrow from the central banks, more accounts are credited

hence more reserves, as well. Since the Great Recession, European Central Bank, Bank of Japan

and the Federal Reserve have permitted the Commercial Banks to buy bonds. It is these central

banks that create the reserves and that is why the negative rate are usually reflected as tax. The

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purpose of this negative rate is to reduce the short-term rates on other lending types. This often

results in weakening of currencies.

How the Central Banks make lending cheaper

Usually, the central banks have a deposit account where commercial banks deposit their excess

reserves. Since the excess reserves are too many, there are a number of banks that want to

eliminate them by lending them to other banks. Due to this competition, the overnight rate

reduces to the same level as the deposit rate. The overnight rate also reduces other rates, which

also influence consumer and business rates (Heath et al 77). The negative rates often incite

investors and banks to purchase things that are more or less like money such as short term debts.

The low rates makes those who invest in Euros to shift to other places that have higher interest

rates, for instance, the United States. These investors often sell their Euros to buy dollars. For

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example, the Swiss National Banks always strive to maintain the weakness of Swiss Franc

against the euro such than when the European Central Bank goes negative, the Swiss Bank will

also go negative (Svensson 45). Analyzing what this impact has towards the economy is quite

challenging. It is still quite mysterious to know the impact of negative rates towards the

economy.

The main business of banks is to lend money to its clients at higher rates. Once they have lent to

their clients at higher rates, they will be able to pay up the depositors. However, currently, the

banks are lending money at very low rates hence they find it quite challenging to pay up the

depositors. On the other hand, the depositors often hold money rather than having the negative

rates (Longstaff, Francis and Eduardo 789). The Central Banks are the source of money for the

commercial banks. When the Central Banks have lent the commercial banks money (in form of

currency notes), they will reduce their reserves. It would be very beneficial for banks to establish

a way of maintaining their clients by charging them negative rates.

(The lending rate is being cheaper)

The Federal Reserve

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The Federal Reserves also have a possibility of going negative as suggested by the chairwoman

Janet Yellen. Currently, the deposit rate of the Federal Reserve is at 0.5 %. However, there are

some organizations connected to the government that have accounts with the Federal Reserve

that are not legible to get the interest payment. Therefore, such organizations often lend their

reserves at 0.5 percent or less. Consequently, the rates of federal funds is often less than the

deposit rate. Suppose the deposit rate went negative, the organizations would lack a lending

incentive.

Countries that have negative Rates

The countries that experience negative interest rates are those with deflation. Such countries

often have reducing prices that are related to weak economic development. In 2014, the

European Central Bank brought the negative rates in countries that use Euros as a currency.

However, countries such as Switzerland, Sweden and Denmark also experience the negative

rates although they are not in the Eurozone. In January 2016, the Central Bank of Japan also

introduced the negative interest rates.

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The bank of Japan is trying to increase the consumer prices, which have been reducing for the

last two decades. The reducing consumer prices have negative ramifications on the corporate

revenues hence companies cannot raise salaries or spend money on new ventures. However, the

efforts of Japan’s banks are wallowing (Duffie, Darrell, and Rui 382). The tool that it has mainly

used is a program that pertains buying of bonds, which are more or less like those of the

European Central Bank and the Federal Reserve. Buying of bonds helps in pumping money into

a country’s economy. Recently, that scheme worked for Japan’s Bank, but has been fading and

the prices are reducing once more.

(The countries that currently experiencing negative interest rate)

The efficiency of the negative Rates in Japan

The value of the Japanese yen was already low and the negative rates made it further lower,

hence the Yen became very cheap. In February, the profit on government bonds dropped below

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zero. Therefore, investors who lend money to the Japanese government are aware that they will

not be fully refunded. However, deflation is still inevitable because the consumer prices reduced

by 0.5 % in July 2016 (Fama 269). Deflation is known to destabilize the efficiency of negative

rates. When the corporate revenues reduce due to the falling prices, firms will find it very

difficult to repay even the most generous loans. Generally, people are always happy when the

value of a currency reduces, but the banks are not really happy. The profits that they are

generating will be reduced due to the negative rates.

(its currency rate moves very closely to its deflation)

The impact of negative interest rates in Europe

Currently, there are about four European Central Banks that have adopted the negative interest

rates and these banks include the Swiss National Bank, the Central Bank of Sweden, and the

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Central Bank of Denmark. These European Central Banks give extra funding to banks through

its program TLRO (Goyal, Rishi, and Ronald 339). With this program, the central banks will be

able to loan other banks at a negative interest rate. The only other option that these central banks

have is to expand their acquisition of assets, or a strategy that involves negative rates. Global

analysts have suggested that the negative interest rates may augment the economic development

in Europe (Fleming, Michael and Kenneth 67). They have also cited some undesirable impacts

that the negative interest rates may have in Europe. One undesirable impact is that these negative

interest rates may make the banks make losses since their interest margins will be reduced.

Organizations that borrow money from banks may also have the same impact. The main

organizations that are being referred to, in this case, are the pension and insurance companies

since these negative rates limit the return on investments (Buiter 729). Such investors can

increase their risk craving to attain the returns required to meet their financial obligations. The

thirst for an advanced return on investment can necessitate borrowing that is very risky.

(The negative interest rate is still going on across the world)

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Negative Interest rates often results to too much risk taking that can bring more credit pressures

and perhaps defaults that have harmful effect on the economy. However, such negative impacts

can be evaded when the policy of negative interest rate is effective in enhancing the GDP

development and reducing the pressures of disinflation towards the economic growth.

Historically, finance is often characterized by negative interest rates. However, the adoption of

this negative interest rates is being seen as either unparalleled or something that is new in an age

of globalized markets.

The European central banks are purchasing government and covered bonds and the most recent

purchase is the securities of private debt. One of the objectives of European Central Banks in the

year 2014, was to decrease the value of the Euro currency. This is a common method that is often

used increase imported inflation and improve on exports. Since the year 2014, the value of Euro

fell from its exchange rate of 1.35 (to the dollar) to 1.10 (to the dollar) (Enders, Walter, and

Clive 304). Consequently, the rate of lending in Europe augmented dramatically, for instance,

the yearly household credit increased from 1.7 percent to 1.6 percent showing a continued

increase in lending. Additionally, the loans to organizations also augmented by 3.6 percent.

Within the Eurozone, the countries that experienced the highest credit development to non-

financial organization were Spain and France.

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(The exchange rate has been tanking since the adoption od negative interest rate)

Within the Eurozone, it is expected that private consumption will be robust. Additionally, there

are signs that there are strong investments, which support the sustainability of the salvage and

this also implies that there is no derailment in the revival of investment as a result of external

headwinds. The recovery of investment is highly likely to improve on its pace considering the

fact that global demand has improved. The rule of negative interest rates does not merely mean

that the central banks have to charge the commercial banks for holding their reserves. Another

rule is that of the Targeted Long Term Refinancing Operation abbreviated as TLTRO. This is a

complex program which proposes that the European Central Banks should loan their money to

banks by offering them a negative interest rate.

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(The actual reflection of negative interest rate)

Negative interest rates and government policies

It is critical to note that the negative interest rates can come about even without the involvement

of government rules. The nominal interest rates are those that are appraised on bonds and loans.

The negative real rates are experienced in an economy that has inflation rates. The real argument

is about the negative nominal interest rates and the policy that regulate the interest rate in central

banks. The central banks often adopt this policy when the country is experiencing a slow

economic development (Eggertsson 139). The central banks adopt this policy because sometimes

there is nothing else that can be done in such a situation. There is another option that can be used

and this is the fiscal policy, however, this is not a policy that the central banks can adopt. This

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policy is politically forbidden and there seems to be an inadequate interest for the government to

take part in it.

However, in some countries such as China and the United States, the fiscal policy works. For

instance, China managed to evade the great recession by augmenting it’s spending on

infrastructure (Black, Fischer, Emanuel and William 33). Similarly, the United States also

recovered through its 2009 spending. Some of the obstacles of fiscal policy is that there are

doubts concerning the efficiency of government spending and the huge debts. One of the most

important arguments concerning the adoption of negative policies is that it helps in reducing the

value of currencies hence augmenting the competitiveness of exports. There is enough evidence

of adoption of the negative interest rate in Japan and other countries that are not within the

Eurozone.

Negative interest rates are introduced by the central banks so that banks may lend more money.

The excess reserves comprise the funds that commercial banks deposit in central banks. Usually,

the commercial banks reduce the excess reserves since it is more gainful to loan these funds

rather than keep them in central bank accounts. When the interest rates have been reduced, the

demand for loan becomes soft and this weakens the economy hence there is a higher risk of

lending money. Banks usually prefer to keep their deposits safe at the central banks rather than

risk lending them at very low interests. Under such a situation, reducing the interest rates does

not encourage the banks to endorse any economic activity or lend money. When the central

banks introduce the negative interest rates, the commercial banks will be forced to lend more

money. This also imposes taxes on the bank’s revenues and these taxes are highly likely to be

moved to the shareholders and customers of the bank.

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Considering the fact that the policies created by the central banks forms the outline of the

economic interest rates, the negative interest rates will be experienced within the entire economy.

The consequence will be eroding of the bank profits. The organizations that will suffer

tremendously are the insurance companies that face the long-term liabilities. These organizations

will heavily depend on bonds since they will find it quite challenging to allocate their assets.

When the negative interest rates move past the main financial organizations to the economy, the

economy will change to one that depends on cash for transactions. With cash transactions, there

is a higher risk of loss through theft.

The limits and logic of the negative interest rates policies

The central banks often control the monetary policy by creating targeted interest rate causing the

financial organizations to lend and borrow reserves from the central bank. The central banks

often have the power to control the reserves, hence they have the power to control its prices, as

well. However, not a large percentage of the economy relies on overnight interest. Central Banks

also have an impact on the economic activities since they influence the overnight rate. It is a

short term goal of the central banks to adopt the negative interest rates to its reserves, just like

the ECB and the Bank of Japan did in 2014 and 2016, respectively (Christie 409). The policy of

negative interest rates is a mere extension of the monetary easing. It also seems that the policies

of negative interest rates pulls down the long-term interest rates. To explain this, one can think of

the inference for the equilibrium of asset marketing.

While the financial organizations must often hold the reserves created by the central bank, the

asset market that is related with negative interest on the reserves will always contrast those with

zero interest rates (Campbell, John and Gregory 389). Consider a government bond that is

contracted for a period of 10 years that has a zero policy rate. A financial organization that hold

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such a bond must be unresponsive between selling that bond and holding it to the central banks

and getting a deposit. When the central banks decide to create a negative interest rate on its

reserves, it will not be very smart to hold those reserves and this will also be true for the ten year

bonds.

One of the most common criticisms of negative interest rate policies is that it erodes the profits

that would otherwise be made by commercial banks (Ang, Andrew, and Geert 163).

Additionally, it represents the bank taxes. Consequently, these two cases forces the banks reduce

its lending. These arguments sound suspicious because the central banks may pressurize the

banks to hold huge amounts of reserves, which could bring negative interest rates.

On the other hand, the negative interest rates can seem too complicated. The effectiveness of

monetary policy depends on the willingness of the central bank to communicate well with the

public. The complicated nature of negative interest rates appears to be at odds with ideologies of

modern banking. However, to add on to the point, suppose the central banks wanted to conform

to such complications and controversies as an instrument of negative interest policy, then it is

logical for the mobilization of the fiscal policy so that the economy can be revived to a complete

employment. When the central banks continue to venture into the issues, the fiscal policies will

become very compelling.

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