What negative interest rate really means

February 16, 2016 16:00
A negative interest rate is aimed at increasing the costs for banks to park excess reserves. Photo: Reuters

Since 2014, the euro zone, Sweden, Denmark, Switzerland and Japan have adopted negative interest rate one after another.

There has been no bank run, and the market has been performing normally. However, some commentators blame the policy for market distortion and declining stock prices.

In fact, negative interest rate does not refer to the market borrowing rate, and only applies to reserves in central banks.

The move is aimed at increasing the costs for banks to park excess reserves. Banks would pass on the costs to their customers.

Depositors, on the other hand, would invest and consume more in light of the negative interest rate.

In theory, the policy does not work. Depositors would rather stockpile their cash at home than pay banks. In such a situation, further rate cuts won’t help; there is a liquidity trap.

Negative interest rate has existed for a long time. Banks usually charge fees for deposits below a certain amount. Depositors need to queue at banks due to the limited number of branches. Banks could hire less employees.

Nevertheless, depositors are still willing to deposit their money in banks because there is also a cost to holding cash, such as the risk of it being stolen.

Still, the cost of holding cash is insignificant. That’s why central banks would usually limit the negative interest rate to negative one percent.

That has provided more room for central banks to cut interest rates.

Will that policy stimulate economic growth? Negative interest rate encourages lending and borrowing, and increases supply of loans in the market.

However, if loan demand remains lackluster, monetary policy won’t be able to change that.

It also depends on whether the negative interest rate is short-term.

If central banks declare that the negative interest rate will be adopted temporarily, that could provide very limited help.

However, if central banks pledge to keep negative interest rate unless some targets are achieved, that would have much greater effect. That’s the difference between discretion and rule.

Last year, the US House of Representatives has passed the Requirements for Policy Rules of the Federal Open Market Committee, which has been supported by a number of Nobel Prize-winning economists, renowned monetary policy experts and former senior officials of the Federal Reserve.

Under the Requirements, the Fed has to explicitly explain the rules for making monetary policy, such as spelling out which economic data it would use as reference. The Fed should also explain to the public if it deviates from these rules.

Some economists believe the Requirements would make the Fed more independent, and it just needs to follow the rules instead of facing pressure to take unconventional measures at special moments. That would also reduce market uncertainty and make Fed’s next move more predictable.

However, there are some tricky issues for the Fed to obey these rules. The target unemployment rate has been cut from 6.5 percent to 5 percent. It remains unclear whether the jobless rate remains a reliable metric for real economic conditions.

In its recent statements, the Fed has been repeatedly touching on the global economic environment. Should it become a part for the rules in determining monetary policy?

In this sense, whether the Fed would reverse its move and join the camp of introducing negative interest rate could be an interesting topic this year.

This article appeared in the Hong Kong Economic Journal on Feb. 16.

Translation by Julie Zhu

[Chinese version 中文版]

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Visiting Associate Professor, Department of Economics and Finance, City University of Hong Kong