The Case for a Negative Interest Rate
- David Song
- Jan 29, 2022
- 3 min read
Since the Financial Crisis of 2007-2008, several central banks such as the European Central Bank (ECB), and the Bank of Japan (BOJ) have deployed negative interest rate policy (NIRP). The ECB first introduced its NIRP in June 2014 when it cut its deposit facility rate, which is one of the three interest rates the ECB sets every six weeks, to negative 0.1 percent. At that time, the ECB implemented the NIRP to mitigate the effects of the Financial Crisis in addition to quantitative easing.
In 2016, the BOJ cut its bank rate to negative 0.1 percent. Since then, many economists argued that a negative interest rate is necessary to help central banks achieve their inflation targets. This article will explore how the NIRP affects the exchange rate and inflation examined in the case of Japan.
Firstly, negative interest rates had led to unintended consequences for investors and commercial banks. Over time, negative interest rates harmed banks’ profitability by eroding their net-interest margins. Japanese banks, for example, initially saw their net-interest margins increase as interest rates on deposits were being reduced faster than the average rates on loans in 2014. Soon thereafter, however, the BOJ’s quantitating easing (QE) had pushed down the yields on loans and bonds, which resulted in steadily declining net-interest margins. Such decline results in a decrease in net profits for commercial reasons, which is one of the reasons why the impact of a NIRP on banks is concerning.
However, there are also benefits that justify many central banks’ policy decisions. Since the late 1990s, Japan has struggled with low inflation — years of low interest rates have crushed commercial banks’ net-interest margins, while the price of property and stock has increased. However, when both central bank and government work together, they are highly unlikely to run out of policy ammunition to offset deflation as they can boost aggregate demand with either fiscal or monetary policy.
Additionally, when a country implements the NIRP, its currency is likely to appreciate in theory. Extremely low interest rates result in a wealth, which makes consumers to spend more as they feel “richer” even though there is no actual change to their income levels (although this is possible for homeowners). This suggests that a NIRP could further boost consumption and borrowing, aiding the economy’s recovery.
According to the BOJ, a negative interest rate would produce a currency depreciation in practice. Although they impose a NIRP on central banks deposits, they have different purposes of depreciating the exchange rate. On the other hand, many researchers consider the effect of NIRP theoretically. For instance, Gunji and Miyazaki (2016) show that NIRP for central bank deposits has a negative impact on bank lending and deposits using a theoretical model that applies the Cournot model [1] to the banking industry and obtained the following results — a negative interest rate on central bank deposits is a cost for commercial banks. Therefore, negative interest rates may strengthen the consumers’ debt services, which may turn into credit losses, leading to lower returns on investment.
In the case of Japan in 2016 where they had an interest rate of negative 0.1 percent, it attempted to prevent the Yen from appreciating in order to avoid a decrease in export volumes — an appreciation of the Yen would have further harmed the economy.
In conclusion, an economy may need a negative interest rate when a country is falling into deflationary periods and currency depreciation in order to increase consumption and export volumes. However, there are other consequences such as falling net-interest margins and lower returns on investment for commercial banks, and the sustainability of a NIRP that must be considered carefully. Thus economic advisers must pay attention to the state of the economy and assess variables in order to maximise the benefits of a NIRP.
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