Negative Interest Rates

Readers Question: Is it possible to have negative interest rates?

Negative interest rates occur when a bank charges you money for the privilege of looking after your savings. It is  possible to have a negative interest rate (e.g. -0.5%) Although it is quite rare. The Bank of England have recently talked about the possibility of a negative interest rate for commercial bank deposits at the Bank of England.

Why is Bank of England Talking about a negative interest rate?

The UK economy is still stagnant with little sign of economic growth. Usually, a prolonged recession would lead to lower interest rates to encourage borrowing. However, since interest rates fell to 0.5% in March 2009, interest rates have stayed the same as there is little precedent for cutting interest rates further.

The Bank has tried quantitative easing but this has not really encouraged bank lending and normal economic activity.

The Bank of England, in particular want to encourage lending to small businesses – small businesses have complained it is very difficult to borrow from commercial banks in the present economic climate.  At the moment, commercial banks prefer to increase their cash reserves, which they deposit at Bank of England and not lend. At the moment commercial banks get a small interest rate payment 0.5% on their deposits. However, if there is a cost for depositing money at the Bank of England, they would have a greater incentive to lend money. In theory, commercial banks will lend more and this would stimulate business investment and economic growth. Higher lending would also help to reduce unemployment and reduce the cyclical budget deficit.

see more on: basic economics of cutting interest rates

How would it work?

The Bank of England would probably introduce a new deposit rate. For example, deposits over £1billion at the Bank of England would be charged the negative interest rate.

The first £1 billion may still receive the base rate of +0.5%. This means that small building societies would not face a negative interest rate. This could cause problems because a negative interest rate could mean they would have to pay people with tracker mortgages (mortgages that follow base rate), and they could go out of business because they couldn’t recoup money from savers. The deposit rate would mainly affect the large commercial banks with high cash reserves.

What would happen to saving rates?

If the Bank of England had a negative interest rates on deposits, commercial banks would be less keen to encourage banks deposits, therefore they may reduce interest rates on saving accounts.  Savers would see a fall in income.

In theory, lower interest rates may encourage spending (rather than saving (substitution effect). However, consumers may be quite inelastic to the interest rate. It may also be outweighed by the decline in income of savers who rely on interest payments (income effect).

What are the Problems of a Negative Interest Rate?

  • Some fear a negative interest rate could encourage a new lending boom. Banks might be so keen to get rid of cash, they start lending to business without evaluating how good the loan is. Austrian economists are particularly critical of negative interest rates as they argue it can lead to asset booms and distort the market. However, there is no sign of a new lending boom in the short term, the real problem is that banks don’t want to lend because of the economic situation.
  • Savers will lose out. With inflation already above target, a fall in the saving rate will lead to an even bigger negative real interest rate. Savers will see a fall in their real wealth and living standards.
  • Banks may still not want to lend. The main thing holding back lending may be the overall state of the economy. Even cutting interest rates to negative may fail to increase lending.

Other Examples of Negative Interest Rates.

In 2012, Denmark had a negative interest rate on its deposit rate.

In Switzerland, there was a brief period where banks charged foreigners who wanted to save in Swiss bank accounts. The reason was that the Swiss were worried about the appreciation in the Swiss Franc. Therefore, they wanted to discourage inflows of money. Charging a negative interest rate means that savers would be losing money to save in a Swiss bank.

In Switzerland, the move was motivated by the attempt to prevent an appreciation in the exchange rate. However, for domestic savers, generally a negative interest rate wouldn’t make much sense. They would be better off keeping their savings in cash or investing in other assets like gold. However, it is theoretically possible banks could charge people to save money with them.

If there was great political turmoil and crime, people may prefer to pay a reputable bank to look after their money rather than keep cash under their mattress. In the absence of  an effective criminal justice system, negative interest rates are more likely.

 

Alternatives to Negative Interest Rates

In a liquidity trap, interest rates have fallen close to zero (e.g. 0.5%) but the economy is still stagnating. There is too little economic growth. And traditional monetary policy would suggest cutting interest rates to boost economic growth. However, because of practical difficulties, only certain interest rates could be cut below zero.

The problem is people are reluctant to spend. Some suggest one solution would be to withdraw certain bank notes from circulation, imposing a cost on customers who hoard cash.

  • There is detailed look at different policies at Vox – Beyond the zero lower bound. serial number.
  • More quantitative easing that instead is focused on increasing bank lending rather than just buying government bonds, e.g. and extension of ‘Funding for lending‘ scheme
  • A government lending bank, which lends directly to small businesses.
  • Helicopter money drop. Give money directly to consumers

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One thought on “Negative Interest Rates

  1. this feels just like what has happened to Cyprus, I advocate full scale debt forgiveness, it works well for individuals who are well aware of their situation
    and have the priviledge to plan for it.

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