Negative Interest Rate Policy

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21 Aug, 2024

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The Negative Interest Rate Policy (NIRP) is a distinctive monetary policy tool a country's central bank uses to reduce the nominal interest rates below zero. The primary purpose of this measure is to boost the economy by encouraging public investment and spending.

The Negative Interest Rate Policy (NIRP) causes the interest rate to fall below the zero lower bound by actually dropping below zero percent. When this happens, borrowing or spending money is more profitable than boosting savings or hoarding cash. When every other measure fails to bring about growth in an economy, the central bank uses NIRP as a last resort. This policy activates market cash flows, making utilization/allotment easy during a financial crisis.

What Is Negative Interest Rate Policy (NIRP)?

The Negative Interest Rate Policy (NIRP) is an unconventional monetary policy that reduces the nominal interest rates below zero.
It is only implemented when a country's economy is sluggish and there is no cash flow in the market. Hence, central banks use interest rates to improve economic conditions.
The Swiss National Bank implemented NIRP in the 1970s.
Without careful implementation and proper monitoring, the policy can backfire, pushing the economy into a deeper financial crisis.

Negative Interest Rate Policy Explained

A Negative Interest Rate Policy (NIRP) is a monetary tool central banks use to give a country’s economy the impetus it needs during a financial crisis or recession or while fighting rising inflation or collapsing financial markets. In such cases, central banks reduce interest rates to below zero. This prompts borrowing and spending, which increases cash flows in the economy.

Many nations have occasionally adopted the NIRP tool to bring change during a financial crisis. Whether NIRP will work has always been a point of debate among economists, with valid arguments being presented about why it may or may not work. Hence, economists closely monitor the negative interest rate policy graph to note the changes. They believe the policy shows the failure of a country’s economic and banking system. Moreover, economists state that applying this tool indicates that citizens have no confidence in the country’s financial infrastructure.

The NIRP is one of the monetary tools that can be used to strengthen a country’s economy. It is employed when central banks find economic revival challenging and all other strategies have failed. Historical records show that NIRP was applied in Switzerland in the 1970s. Sweden saw the negative interest rate policy of the central bank being enforced in 2009, while Denmark used it in 2012 to fight economic problems. Japan used this tool in February 2016 when the inflation target they set earlier could not be met. The 2008 financial crisis and the COVID-19 pandemic brought economic gloom, and the NIRP was taken under advisement as a probable measure.

NIRP must be planned and implemented for a fixed time since it can unleash more problems and risks. Hence, the longer it remains, the more it impacts a country’s financial and political stability.

Implementation

The implementation of NIRP has been explained below.

When the negative interest rate policy is implemented, banking and financial institutions pay interest on the cash they hold (in addition to the standard reserve requirements). If they loan funds to individuals and businesses, they need not pay interest charges to the central bank. Eventually, this boosts growth as more people begin securing the money they need to transact or run their businesses.
Reducing the interest rate below zero is not the only step central banks take to fight an economic downturn. They strive to restore and maintain people’s confidence in the economy and the banking system.
Typically, banks ensure they do not default on their banking duties and services. They also endeavor to avoid probable bank runs.

Examples

Let us study a few examples that explore the negative interest rate policy further.

Example #1

In 2019, many Scandinavian countries, such as Sweden and Denmark, introduced negative interest rates. It indicated that their economies had become static, and banks offered negative interest rates to encourage people to spend instead of keeping money in bank accounts.

Denmark's third-largest lender, Jyske Bank, offered a home loan with a tenure of 10 years at a -0.5% annual interest rate. Similarly, Nordea proposed a 20-year fixed interest rate home loan at 0% and a home loan with a tenure of 30 years for 0.5%.

Further, Jyske Bank’s home loan scheme was relatively complex. When a borrower repaid the loan in installments, the outstanding amount (with every installment) was reduced by an amount higher than that paid by the borrower.

Example #2

In September 2022, the Swiss National Bank withdrew the negative interest rate policy. The policy had been in force for 7.5 years. The bank tightened its monetary policy to fight inflation. The Swiss National Bank increased the interest rate by 0.75%. Due to this, the Swiss bond yields declined. This decision aimed to regulate prices across various sectors.

Effects

The effects of the negative interest rate policy have been summarized below.

The money held by banks attracts charges (payable to the central bank). Hence, banks do not earn interest but incur expenses on this money.
Penalizing individuals and businesses for saving money can backfire. Those who have cash will likely face problems arising from hoarding it, as saving money and hoarding cash becomes expensive. Therefore, savings in the economy decrease.
Money market funds offer lower returns when NIRP is applied. This disruption can dramatically impact cash flows.
Spending money and investing in the market becomes easy. Hence, market spending increases. The policy encourages individuals and businesses to spend, which may result in market cash flows being regulated by them.
Borrowing becomes cheap and easy for both individuals and businesses.

Frequently Asked Questions (FAQs)

1. What are the benefits of a negative interest rate policy?

The benefits of a negative interest rate policy are:
● It encourages people to spend money and leverage the negative borrowing rate.
● The NIRP incentivizes consumer spending and investment.
● A negative interest rate policy is unconventional. Hence, at times, it works.

2. Is the negative interest rate policy good for an economy?

Yes, it usually works well for some time. However, when the NIRP is kept in force for a long time, it can backfire. When a negative interest rate policy is introduced, banks must pay charges to the central bank for cash holdings. Therefore, loaning funds is preferred. In fact, spending or investing money instead of hoarding cash makes more sense in such situations.

3. What are the disadvantages of a negative interest rate policy?

The disadvantages of a negative interest rate policy are:
● It serves as a last resort for flailing economies. Usually, central banks do not prefer this monetary policy tool.
● There is no guarantee that the NIRP will revive the economy or stabilize it.
Without proper implementation and control, a country’s central bank is vulnerable to the NIRP backfiring