Negative interest rates pose a major challenge for central banks, requiring effective strategies and policies to mitigate the negative impact on the economy.
Negative interest rates describe an unconventional economic situation in which nominal interest rates fall below zero. Instead of earning interest on their deposits, depositors pay a fee to keep their money in a bank. This traditional understanding of negative interest rates is familiar. However, negative returns can also be caused by inflation. When nominal interest rates are lower than the inflation rate, depositors earn less interest on their savings than the rate of price increase. As a result, their purchasing power decreases over time. For example, if you have a deposit earning 20% annual interest and the annual inflation rate is 30%, the purchasing power of your money effectively decreases by 10% per year (20% nominal interest rate minus 30% inflation rate).
Understanding the causes of negative interest rates and analyzing their nature is crucial to developing effective strategies to combat them. Negative interest rates can arise from a variety of scenarios, each with their own unique causes, advantages, and disadvantages.
Negative nominal interest rates: They arise from central bank monetary policies aimed at stimulating economic growth. In such cases, central banks adopt ultra-loose monetary policies to stimulate economic activity. Typically, there is no liquidity gap, the exchange rate is stable, inflation is within target, and the propensity to save exceeds the propensity to invest. Under these conditions, negative interest rates are consistent with monetary policies aimed at economic growth. Negative interest rates make financing for economic activity cheaper, encouraging borrowing and spending rather than saving. As a result, economic activity and growth are stimulated. Negative interest rates also reduce borrowing costs for businesses and individuals, potentially increasing business investment and consumer spending. In addition, governments can borrow at lower costs and, in some cases, even get paid by creditors for depositing money in banks.
Negative real returns due to inflation: This type of negative interest rate occurs when the inflation rate exceeds the nominal interest rate. Deposited funds lose value and purchasing power over time. Factors that contribute to this phenomenon include central bank monetary policies, economic and political developments, and global events such as financial crises. Addressing this situation requires precise policy adjustments and effective management strategies.
Negative interest rates have several effects.
Savings and investment: Negative interest rates could discourage savings and harm individuals who rely on interest income. Some may withdraw money from banks to avoid paying interest, resulting in less liquidity in banks.
Bank profitability: Negative interest rates can adversely affect bank profitability by reducing interest margins on loans and deposits.
Positive: On the positive side, negative interest rates make borrowing costs cheaper for businesses and individuals, stimulating business investment and consumer spending. They also reduce the cost of government debt.
Several countries, including Japan (one of the first to introduce negative interest rates) and European Union member states such as Switzerland, Sweden and Denmark, have implemented negative interest rates to address various economic challenges.
Central banks and governments have taken several measures to address the challenges posed by negative interest rates. Central banks may raise nominal interest rates to match or exceed inflation, if economic conditions permit. This approach requires caution to avoid the risks of economic slowdown and stagflation. Central banks will closely monitor the impact of negative interest rates and adjust monetary policy accordingly. They may also apply negative interest rates to some deposits to reduce the adverse impact on commercial banks and cushion savers' reactions.
Dealing with negative real returns requires innovative and flexible investment strategies. Individuals and institutions can invest in assets that protect against inflation, such as inflation-protected bonds and real estate, or diversify across assets such as stocks and precious metals.
Negative interest rates, whether nominal or real, pose significant challenges to governments, economic activity and individuals, especially during periods of high inflation. Effective management requires a comprehensive strategy that includes monetary policy, fiscal policy, economic diversification, education and awareness raising. By adopting these measures, central banks and governments can increase economic stability and mitigate the adverse impact of negative interest rates on the economy and its people.
OPINION | How negative interest rates affect the economy and the public