When the economy is in crisis, central banks take center stage.
Central banks are charged with keeping prices stable
and ensuring economic growth, among other responsibilities.
To that end, they have a range of tools at their disposal,
including controlling the supply of money, setting interest rates
and regulating private lenders.
But one idea being talked about as a way to shore up a shrinking economy
has the potential to turn the way we think about money upside down.
Negative interest rates.
In June 2014, the European Central Bank began a great economic experiment.
Faced with slow economic growth and inflation way below the bank’s target rate,
the bank did something revolutionary. It began to charge a negative interest rate.
To understand why this was so radical, it’s important to think about how interest rates work.
Anyone lending money usually expects to be paid a fee, known as interest,
to cover the risk or inconvenience of not having their cash to hand.
We see this with banks paying interest to savers and consumers paying interest on home loans.
The cost of borrowing, as a percentage of the original sum loaned, is the interest rate.
But negative interest rates turn the world upside down,
with borrowers charging lenders for holding onto their money.
So, what are central banks trying to achieve by making interest rates negative?
Imagine a big lever that they push back and forth as they attempt to keep the economy on course.
When central banks transact with major financial institutions,
changes in the rates received by these lenders gradually ripple out
through the wider network of commercial clients and consumers.
When prices are rising and there are fears that the economy is expanding
at an unsustainable rate, central banks pull back the lever
and raise interest rates, making loans more expensive.
But if inflation is falling and the economy isn’t growing
as fast as it could, central banks push the lever
and lower the cost of borrowing to stimulate demand and encourage spending.
But what happens when interest rates are already low and there isn’t enough lending and spending
to spark the economy back to life?
Central banks can charge financial institutions for not putting their money to work.
In the same way that you or I might put any spare cash into a savings account,
commercial banks store their reserves with central banks.
In a world of negative interest rates, instead of paying interest on these savings,
the central bank charges financial institutions for holding onto them.
The idea is to encourage banks to lend this money
to consumers and businesses, even if they don’t expect a big return.
As consumers spend and firms invest for the future, the economy begins to grow again.
So how have negative interest rates worked out in the real world?
In the wake of the Great Financial Crisis, central banks across the globe
cut interest rates to fight the recession.
...that's towards the aggressive end of the rate cuts...
...another three quarter point cut...
...unprecedented rate cut...
Just a few years later, five central banks found themselves facing further economic difficulties,
and took the plunge into negative territory, pushing their headline rates below zero.
Although intended as temporary measures, none of these institutions
have yet been able to lift rates above zero for very long.
The European Central Bank believes its negative interest rate policies
have been responsible for up to 0.5% of economic growth in the euro zone since 2014.
That may not sound all that impressive, but it still represented more than $65B of GDP in 2019.
Elsewhere results have been mixed, with the Swedish Riksbank abandoning
its negative interest rate policy despite failing to consistently reach its inflation target.
What’s the biggest threat to negative interest rates then?
Cold, hard, cash.
Why watch your savings shrink when you can have a form of money that holds its value instead?
For large financial institutions dealing with billions of dollars,
withdrawing everything and stuffing it under the mattress isn’t an option.
This means they’ll accept the pain of rates being pushed a little way below zero
as the price of knowing their money’s safe with their central bank.
But banks are wary of passing on negative rates to businesses and consumers with smaller balances,
who may find it easier to switch to cash rather than see their savings shrink.
If the difference between the central bank rate and the rates they pass on to customers gets squeezed,
that means banks stand to make less profit.
Although that may not sound like a tragedy, it’s possible that pushing the interest rate lever too far
may put banks under too much pressure and cause them to lend less.
That’s the opposite of what central banks are looking for when they lower rates.
Some economists think this ‘reversal interest rate’ is likely to be around -1% in the euro zone.
So far, the lowest central banks’ main policy rates have sunk is -0.75%.
While Danish banks have offered mortgages with negative interest rates to prospective homeowners,
consumers still aren’t quite being paid to borrow once fees are taken into account.
And saving for the future is more difficult than ever as savings accounts and pension funds offer low returns.
A negative interest rate policy may have its limits, and it certainly won’t head off deflation or recession alone.
But in a world of low interest rates, don’t be surprised if more central banks
look to turn the world upside down as economic uncertainty looms.
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