Accentuating the Negative

It's a phenomenon not seen in Australia, but around the world an increasing number of central banks are adopting a negative interest-rate policy in a bid to spur lending and business investment in their sputtering economies.

 

Negative interest rates are just as they suggest – the depositor pays the bank to look after its money rather than earning interest on the deposit.

 

In practice, the model usually works by way of a country's central bank charging commercial banks to deposit their excess reserves with them, rather than retail customers being charged by those commercial banks (although this is not unknown).

 

By penalising banks who park cash with them, central banks are trying to persuade commercial banks to instead lend the money to consumers or businesses, in the hope that those consumers and businesses will then spend the money, thus boosting the economy and contributing to inflation.

 

The policy can also be used to push investors to shift money out of bank accounts and into higher-yielding – and usually riskier – assets.

 

The first major central bank to employ a negative interest rate policy was the European Central Bank in June 2014, followed by the Swiss National Bank in December 2014. The latest major central bank to ‘go negative’ was the Bank of Japan in January 2016, although both the Swedish and Danish central banks have also used a negative interest rate policy in recent times.

 

One problem with such a drastic policy is that it usually signals a central bank has exhausted all of its other options to stimulate economic growth.

 

In addition, if commercial banks do pass the impost on to their depositors, then those customers may decide to withdraw their funds from the system and put the cash 'under the mattress', creating a situation where the consequences of the policy have the opposite effect of that intended.

 

Even if banks do not pass on the costs, the narrowing of the margin between lending and deposit rates may make them less inclined to lend, again creating an unintended consequence.

 

It is also worth noting that as central bank rates are the benchmark for all borrowing costs, then negative interest rates will also flow through to the market for fixed-income instruments. Some estimates have around one-third of debt issued by governments in the euro zone as showing negative yields as at the end of 2015 – implying that investors who hold the securities to maturity will not get all their investment back.

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