Negative Interest Rate

A negative interest rate is when the banks charge interest from customers for storing cash with the bank. The prime reason for such a charge is that people generally prefer to retire money instead of spending it or investing the same at times of deflation. As a result, consumer spending increases and demand for products and services also rise.

A negative interest rate policy of banks, including central banks and private banks, works in the economy so that the overall demand of the elements of the economy like households, industrialists, capitalists, etc., increases for products in the market. So basically, by making the interest rate below zero, the cost of investing rises, and borrowing costs reduce.

• A negative interest rate is when the banks impose customer interest for storing cash with the bank. The primary objective for such a charge is that people usually retire money rather than spend it or invest the same at deflation times.
• The government may offer the policy of charging these rates under deflationary economic pressures. Thus, it helps the economy to regulate the demand-supply level and to grow in the situation of deflation. In addition, it further incentivizes banks, producers, and suppliers to continue providing deposits or producing the output to run the economy.
• A hostile interest rate policy is like taking a loan from the bank, where the borrower gets paid for the loan. Therefore, in this policy, the bondholder pays the interest to the issuer. Hence, the situation is opposite from the normal economic cycle.

Negative interest rate is when the inflation rate of an economy is say, 4 percent and the interest rates for borrowing are 3 percent. Therefore, the real interest rate is negative. This situation motivates banks and other financial organizations to lend more and consumers are naturally more attracted to borrow as the interest rates are virtually non-existent.

Ultimately consumer spending rises when the interest rates are low and the demand for essentials and other products rise steeply despite the increase in price due to high demand.

These further have two effects, the producers and suppliers are encouraged to manufacture and supply and, the bankers are incentivized to create more deposits.

Thus, in the situation of deflationary pressures in the economy, the government can provide the policy of charging these rates, thus helping the economy to maintain the demand-supply level and to grow in the situation of deflation, further providing an incentive to banks as well as the producers and suppliers to continue to provide deposits or produce the output to run the economy.

These negative interest rate countries allow their banks to charge a negative interest rate in their economy:

• Denmark’s government is charging the negative interest rate of approx. -0.7%
• European govt. allows the banks to charge the negative interest rate of approx. -0.4%
• Also, Switzerland, Japan, Denmark is included in those countries.

Let us understand the concept of negative interest rate bonds and other similar concepts with the help of a couple of examples.

Example #1

Jason is a marketing associate at a local manufacturing unit in New Jersey. The monthly recurring income from the job suffices for all household expenses and monthly investing schemes. However, there is almost never a situation where there is excess cash for spending on a vacation or anything for leisure.

When the banks started lowering their interest rates below the inflation rates, he was fascinated by the idea of securing a loan with virtually no interest. The inflation rate was 3 percent and loans were available at 2 per cent.

He secured a loan for $15,000 and used the amount to fulfil his and his family’s wants.

Example #2

In December 2022, the Bank of Japan (BOJ) showed signs stepping back from being one of the negative interest rate countries. This decision came in the light of the expansion of the Japanese Government Bonds (JGB).

In a dire need to increase the functioning of JGB, it planned to scrap the negative interest rate and thereby, the JGB’s yield curve control would develop similar to the development due to policy tweaks they made weeks before this announcement.

It is a gainful situation for consumers to secure loans at an interest rate below the inflation rate of the economy. However, it is equally important to understand how to calculate negative interest rate bonds and loans from banks. Let us understand how through the discussion below.

As mentioned earlier, It is one of the last resorts to boost the economy where other conventional ways prove to be insufficient in this situation. Basically, in deflation, there is minimal pressure on banks to offer deposits. Thus, by lowering the interest burden and then making it negative, the cost of borrowing of the households and companies reduces, increasing the demand for loans and increasing household spending.

They further prevent passion for the reduced costs of the cash deposits to small lenders and depositors and hoarding the cash and earning the income on such deposits. It is how the whole situation works.

Undertaking a loan in a situation with little to no interest rates is a good solution in terms of cashflow. However, it is not free of risks and hurdles as it has been seen in multiple negative interest rate countries. Let us understand them through the points below.

• Firstly, with an increase in investment costs, it is not always so that the people are encouraged to borrow money and increase their spending. It was the cycle of growth in the economy of the country that broke.
• It affects those industries, lenders, and institutions that are solely based on lending the money and not accepting the same since now they have to pay interest and lend money.
• For banks, to raise the income from the storage of cash of the investors, the banks' risk also increases with regards to the assets of the banks and further results in an asset bubble.
•  It becomes difficult for the banks to create a capital buffer since the bank faces problems over cash deposits by attracting more investments and increasing the investors' confidence.
• Enterprises working in developing countries face problems of over-lending as per the specific regulations of the law.

Similar to multiple situations in the market where, utilizing opportunities and taking calculated risks are extremely rewarding, investing in something like negative interest rate bonds can also be extremely profitable. Let us discuss such possibilities through the explanation below.

• A negative interest rate policy is like taking a loan from the bank, and the borrower gets paid for the loan. Thus, under this policy, the bondholder pays the interest to the bond's issuer; thus, the situation is exactly opposite from the normal economic cycle.
• Thus, we can make money from this situation by accepting deposits, borrowing funds, and offering bonds and other financial instruments. Also, banks and other money lenders and money traders can reverse the gap between money lending and money borrowing or holding cash deposits and earn the difference in the interest rate.
• Thus, they offer more loans and accept fewer deposits to earn the interest gap. They need to reverse the gap and continue to make money from the differential interest.

The push and pull of the market are adversely affected in negative interest rate countries. Let us understand the impact it has on the economy overall through the discussion below.

• During periods of deflation, bringing the economy to a normal level is very important. Hence, simply cutting the interest rates to Nil is never enough to encourage borrowing and lending. And hence in such a situation, these rates are very advantageous.
• It stops the fall in the demand level and a stoppage in the production of outputs by the manufacturers and industrialists due to a reduction in price levels during deflationary pressures.
• Employment opportunities increase by charging these customers' rates and encouraging banks to provide further cash deposits.

This has been a guide to Negative Interest Rate. Here we explain how negative interest rate works along with its risks, reasons, and examples. You can learn more about finance from the following articles –

• Economic Utility
• Interest Rate Risk Types
• Nominal Interest Rate Calculation
• Inflation vs Interest Rate