A Negative Interest Rate Policy (NIRP) is an innovative monetary policy tool employed by central banks, wherein nominal target interest rates are set with a negative value, below the theoretical lower bound of zero percent. Developed mainly since the 1990s, NIRP has been implemented under extraordinary economic circumstances to mitigate financial crises.
Key Takeaways
- A Negative Interest Rate Policy (NIRP) occurs when a central bank sets its target nominal interest rate at less than zero percent.
- This extraordinary monetary policy tool strongly encourages borrowing, spending, and investment rather than hoarding cash, which loses value to negative deposit rates.
- Officially set negative rates have been practised following the 2008 financial crisis in regions such as Europe and Japan.
Explaining Negative Interest Rate Policies
A negative interest rate means that the central bank (and potentially private banks) charges negative interest. Rather than receiving money on deposits, depositors have to pay regularly to keep their money with the bank. This practice intends to incentivize banks to lend more freely, prompting businesses and individuals to invest, lend, and spend money rather than paying fees to keep it secure—these actions occur during a negative interest rate environment.
During deflationary periods, people and businesses often hoard money instead of spending and investing. This behavior results in a collapse in aggregate demand, causing further price declines, a slowdown or halt in real production and output, and an increase in unemployment. A loose or expansionary monetary policy usually addresses such economic stagnation. However, if deflationary forces are intense, cutting the central bank’s interest rate to zero might not be enough to stimulate borrowing and lending.
The Theory Behind Negative Interest Rate Policy (NIRP)
Negative interest rates can be considered a last-ditch effort to boost economic growth, implemented when traditional policies have been ineffective or failed. Theoretically, targeting interest rates below zero reduces borrowing costs for companies and households, driving demand for loans and sparking investment and consumer spending. Retail banks may opt to internalize the costs of negative interest rates, affecting profits instead of passing these costs to small depositors who might otherwise move their deposits into cash.
Real World Examples of NIRP
An example of a negative interest rate policy could be setting the key rate at -0.2 percent, compelling bank depositors to pay two-tenths of a percent on their deposits instead of earning positive interest.
- Switzerland: The Swiss government operated a de facto negative interest rate regime in the early 1970s to prevent its currency from appreciating due to global inflationary pressures.
- Sweden and Denmark: Sweden in 2009 and 2010, and Denmark in 2012, adopted negative interest rates to deter hot money flows into their economies.
- European Central Bank (ECB): In 2014, the ECB instituted a negative interest rate on bank deposits to avoid a deflationary spiral in the Eurozone.
Risks and Unintended Consequences of NIRP
There are potential risks and unintended consequences associated with NIRP. If banks penalize households for saving, this might not necessarily spur more consumer spending; instead, households may hoard cash at home. A negative interest rate environment could even instigate a run on cash, causing households to withdraw their funds to avoid paying negative rates.
Banks can avert cash runs by not applying negative interest rates to smaller household deposits, focusing instead on larger balances held by pension funds, investment firms, and corporate clients. This strategy encourages corporate savers to invest in bonds and other vehicles, securing better returns while protecting the bank and economy from adverse effects.
Explore the complexities of a Negative Interest Rate Policy (NIRP), understand its intended economic stimulation, and prepare for possible challenges, enabling well-informed financial decisions.
Related Terms: Monetary Policy, Interest Rates, Central Bank, Deflation.
