Imagine rates so low that they’re actually in the negative. Instead of making money off your investment, you would have to pay the bank to house your cash. Although it may not even seem legal, negative interest rates are a real possibility. In Europe, interest rates at certain central banks have fallen below zero. The European Central Bank was the first bank in the nation to see negative interest rates in 2014. Japan is also currently testing out negative interest rates. Basically, negative interest rates are a last-ditch effort to stimulate the economy when other options are exhausted. The strategy may seem unconventional to consumers in America, but it’s something world banks could adopt if the strategy proves successful in other countries. While there are a few goals the negative interest rates are designed to accomplish, there is an argument for why it could backfire.
Promoting Local Lending
One theory is that negative interest rates at central banks would encourage banks to lend more money to consumers and businesses. Rather than pay the central bank, the negative interest rates would entice banks to lend money, which will at least make the local banks money. The money is distributed to people who can repay the loans, plus interest. Although it’s a move that can get local banks to lend, negative rates charged by the central bank may be passed on to the customers at local banks. To compensate for the fees the banks pay for storing cash, they’ll charge account holders negative rates as well. Naturally, consumers don’t relish the idea of being charged to store their money in a bank. In turn, individuals may choose to forgo the banks altogether and hoard their money elsewhere. When consumers store their money in safes or under their mattresses, lenders lose out on funding sources. Less money in the bank, means less money to lend. Shrinking profit margin may also result in tighter lending standards.
Warding off Inflation
Negative interest rates can ward off inflation by driving down the value of the currency. In Europe, the theory is that the rates will weaken the demand of the euro and drive off foreign investors. Depreciated currency can stimulate the demand for exports, again helping the economy. On the other hand, exports can become more competitive, which leads to inflation.
In Japan, markets reacted unfavorably when news about negative interest rates surfaced. The impact on the market may be related to how well the negative interest rate policy is communicated to the public. If not thoroughly explained, consumers may make assumptions, which lead to panic and weary investors in the United States. Understanding the theories and purpose of negative interest rates is crucial.
Negative Rates in the U.S.
We are yet to see negative interest rates in the United States, but it doesn’t mean that we won’t see them in the upcoming years. If the negative rates prove successful in Europe and Japan, we could also see historically low rates. The U.S. money market is the largest in the world. The money market plays a pertinent role in supplying the liquidity necessary to help businesses meet their short-term finance needs. Negative rates could be very disruptive in the U.S.
The Bottom Line
There is still much debate on whether negative interest rates are really beneficial. Since the negative rates are still experimental, there are unknown consequences. However, there is no longer any question of the central bank’s willingness to dabble with sub-zero interest rates. Based on simple economic theory, lower rates — even negative rates — are always a stimulant. Higher interest rates are more restrictive. Although that is the theory, there is always a risk. When venturing into uncharted territory, the risk increases.