The Death of the Zero Lower Bound: Negative Nominal Interest Rates
It is believed that Mario Draghi will cut the ECB’s deposit rate even lower, and will increase the Eurozone’s Quantitative Easing programme, in order to increase aggregate demand in the Eurozone. Meanwhile, the Fed is set to increase interest rates. It seems that the two largest economies are pursuing diverging policies. However, of particular interest is that Draghi seems to have broken the zero lower bound ‘rule’.
Usually, to stimulate an economy, the central
bank would lower interest rates so that borrowers borrow more and spend more
money in the economy, and businesses borrow more, invest more and create
further employment, thus stimulating the economy further. However, when the
interest rate is higher than the inflation rate people have an incentive to
hold their money in the bank- as the real interest rate is above 0. The problem
occurs when deflation appears, because interest rates are above 0, meaning that
people still have an incentive to save their money as they would earn interest
on it, and in the future they also expect prices to be lower. In order to
combat the deflationary spiral, Central Banks have the option to pursue
unconventional monetary policy- and one of these policies is the use of negative
interest rates.
Currently the discount rate at the ECB is -0.2pc- this means that banks are effectively
paying the ECB to hold their reserves. Therefore, Draghi’s policy of negative
interest rates should encourage banks to lend to businesses, thus stimulating
investment and employment. It is also
hoped that banks will also pass on the negative rates to laymen, encouraging
them to also withdraw their money from banks and consume it in the economy.
On the other hand, this may not guarantee
increased spending, as consumers decide to store money at home rather than
leave it in the bank or spend it. As a result, due to a reduction in the supply
of money in the banks’ reserves, interest rates are likely to increase. Although
the resulting interest rates would probably be only very slightly positive, and
so increasing the incentive to borrow, it is likely that a bank-run would
precipitate before such an occurrence. Moreover, building societies in Britain
have assets such as mortgages with variable interest rates. Should interest
rates fall below zero, this would result in lower profits for the banks, thus
reducing capital.
However, in Denmark interest rates are -0.75pc,
with the Danske Bank currently charging
negative interest rates for large deposits- i.e. deposits by businesses. However,
there have not been any noticeable repercussions. Rather than forcing
businesses into ‘hiding’ money, this has actually resulted in businesses withdrawing
money from the bank for investment
purposes, thus increasing employment. Some depositors have also left their
money in the bank, willing to pay the premium
as they feel that if they took their money out of the bank and stored it elsewhere,
it would not be as safe.
Other examples of countries adopting negative
interest rates are Sweden and Switzerland. Sweden hopes to increase inflation
by adopting a negative interest rate. On the other hand, Switzerland and
Denmark have decided to establish negative rates in order to prevent their
currencies from appreciating, with Denmark also adopting a negative rate in
order to maintain its exchange rate peg with the Euro. The Swiss government has
issued 10-year government bonds at rates below 0. This is because investors are
less likely to demand Swiss Francs if the rates are negative, thus ensuring
that the Franc does not appreciate. An appreciation would result in Swiss
exports becoming more expensive, and so potentially reducing the rate of
increase in aggregate demand. However, by deterring investors away with
negative interest rates, the Swiss government hopes to depreciate the currency
slightly, thus increasing revenue from exports.
It is presumed that Draghi hopes that a
negative interest rate would have the same effect on the Eurozone- depreciating
the currency and so raising the price of imports. Indeed, the Euro has fallen
by 20pc against the dollar since the
introduction of negative interest rates. This would therefore, it is hoped,
help to combat deflation and increase the incentives for citizens to spend
today, because prices would be expected to rise tomorrow.
However, initially this seems
counter-intuitive: why would an investor invest in a bond with a negative
interest rate? Firstly, it is highly unlikely that the Swiss government would
default, thus increasing the incentive for people to invest in Swiss government
bonds. Furthermore, an investor in the Eurozone may believe that the Swiss
franc would appreciate against the euro in the future. Therefore, they may buy
Swiss government bonds in the hope that the resulting money gained at the end of
the 10 year period outweighs the ‘loss’ of a negative interest rate. Moreover,
other investors may believe that the yields on government bonds will continue
to decrease, and so they buy government bonds with negative yields in the hope
of selling them when the yield falls even further, and thus at a higher price.
With inflation in Switzerland currently at -1.1pc, with the rest of the Eurozone averaging -0.1pc, and
the price of Brent Crude remaining low, it could mean that countries in Europe
will further slash their interest rates. However, the question still remains
whether the negative rate will be passed on to laymen.
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