Another very good video from Tom Chitty at CNBC. He explains how negative interest rates in theory are supposed to work but also looks at some of the problems that might eventuate. Very good for macro policy Unit 5 CIE and NCEA Level 2 and 3.
Central bankers around the world have been toying with the idea of going into negative territory with interest rates. The economic indicators influencing their decision tend to focus on the inflation rate and the amount of spare capacity – output gaps. Some research has suggested that interest rates needed to go as low as -6.5% (UK in 2013) and -3% ( USA in 2014) to stimulate growth.
Negative interest rates does encourage people to take money out of their bank accounts and store in safe deposit boxes or under the mattress, the latter being vulnerable to theft. This makes the process of buying goods/services difficult – do you carry a lot of cash as electronic transfer is no longer used? Additionally online transactions would disappear with people holding cash. According to The Economist central bankers face three important questions.
- The technical feasibility – rates could be pushed lower by getting rid of high-denomination banknotes and impose fees on large transfers might raise the cost of hoarding cash by enough to allow rates to be cut further.
- Hurting growth – negative interest rates can weaken demand rather than boosting it. As commercial banks have to keep reserves at the central bank negative interest rates means that they are losing money. However the commercial banks may not want to pass these costs onto customers so their profits are squeezed. This is especially a concern for less profitable banks that may limit their lending and ultimately investment and growth.
- Is it worth it? Is the easing of interest rates into negative territory enough to make the difference between a strong recovery or a weak one. Also will people still borrow when rates are negative. Even with the low rates today borrowing levels are not significant and even if rates went negative would it make any difference? Consumers are worried about taking on debt with job security a concern therefore borrowing is not a top priority.
In order to kick start the economy there needs to be more fiscal expansion. Giving people money with a wage subsidy or just crediting their bank accounts would be more effective in achieving more economic activity.
Source: The Economist – Should the Fed cut rates below zero? 23rd May 2020
The Free Exchange column in The Economist referred to negative interest rates as neither unfair of unnatural. Irving Fischer used the metaphor of the world’s oldest ship’s biscuits from a voyage back in 1852. Known as hardtack these biscuits were renowned for their longer storage life and therefore making them an important source of nutrition for sailors.
Fischer wrote in ‘The Theory of Interest’ in 1930 an imaginary scenario where a group of sailors are shipwrecked and the only food they have to sustain them is hardtack. Fischer proposed the question ‘under what circumstances would sailors borrow and lend biscuits? For most people interest is the reward for saving and delayed satisfaction so negative interest rates would seem to be unjust. In the case of shipwrecked sailors if one of them is prepared to lend another a biscuit the lender would want more than one biscuit in return and the more hungry they are the higher the interest rate. However Fischer pointed out that the interest rate should be zero as if it were positive it would mean that the sailor would have to take more than one hardtack biscuit to repay the loan. However no sailor would accept these terms as he could instead eat one more piece from his own supply, thereby reducing his future consumption by one hardtack biscuit. And a sailor who had already depleted his supply would be in no position to repay borrowed biscuits. If for instance the sailors were washed ashore with perishable items the interest rate would be negative – Fischer concludes that the rate of interest for any commodity should be negative not positive.
Recently banks in Japan, Switzerland, Denmark and Sweden started charging customers for saving money which asks the question why should people pay to keep their money in banks when they had already earned it? But charging customers interest is a natural occurrence when you consider that savers preserve their purchasing power without any care required to prevent any resources eroding. In 1916 economist Silvio Gesell gave his treatise in favour of negative interest rates on money. His said that storing wealth required considerable effort and ingenuity especially commodities like meat, wheat, fruit etc which are perishable. Gesell said that our goods rot, decay, break and rust. Only if money depreciated at a similar pace would people be as anxious to spend it as suppliers were to sell their perishable commodities. To keep the economy going he wanted money to rot like potatoes and rust like iron.
The negative interest rate introduced by Japan accompanied by an inflation target three years before is in effect pursuing Gesell’s dream of a currency that rots and rusts, albeit by only 2% a year.
Source: The Economist – Free Exchange – 3rd February 2018
The aim in many developed countries is to stimulate economic growth and to raise inflation within the target bands as stipulated by many government’s central banks. For some countries the immediate objective has been to prevent their currency from rising making their exports more expensive and imports cheaper. Therefore the thought of negative interest rates discourages investors from buying your currency which would push up its value. The EU, Denmark, Sweden, Switzerland and Japan, central banks have decided to have a negative rate on commercial banks’ excess funds held on deposit at the central bank. In effect, private sector banks have to pay to park their money – see graph below.
New Zealand is currently in a bit of a predicament in that the OCR (central bank rate) is at 2.25% which is relatively high compared to other central banks and therefore does attract ‘hot money’ into the economy – money that ‘parks’ to earn interest. However if they drop interest rates to ease the pressure on the NZ$ they run the risk of further inflating the housing market by making borrowing cheaper.
For the consumer as soon as the rate banks offer fall below 0%, savers have an incentive to withdraw their money and put it under the mattress. By charging negative rates the central banks are hoping that the trading banks will keep more of their money and therefore lend it out to investors. However the desire to reduce a banks reserves is futile as if someone borrows money from a bank and buy a new car the money is paid to the car company who will then deposit the money in their account which increases the reserves of the bank.
Overall negative rate reflect the constant state of weak aggregate demand in many developed economies since the 2008 financial crisis. Central banks have kept their policy interest rates very low to stimulate economic growth and more recently to get higher inflation. However, how low can they go?
Below is a very good cartoon from the FT looking at negative interest rates.