What are negative interest rates?

You may be wondering how an interest rate could be negative. So, let's take a brief look at "negative interest rates". Firstly, what are they? As the name suggests, the rate is literally negative, i.e., it is below zero. In essence, this means that it costs you to keep your money at the bank, and in effect, your cash deposit incurs a storage charge, rather than interest income.

Why would this type of scenario be encouraged? This is primarily to encourage loans and spending, rather than savings and hoarding of funds. This is a tool for struggling economies to prevent deflation. Since individuals and banks are charged money for holding savings rather than being paid interest, they don’t have an incentive to keep the money in the bank. Countries who employ negative interest rates attempt to boost the economy by encouraging banks and consumers to take more risk through borrowing and lending.

This type of strategy has been used by the European Central Bank (ECB), Switzerland, Denmark, Sweden and Japan but has not yet been used in the UK, Canada and the USA. Despite their reluctance to use negative interest rates, the USA and Canada came very close to using them during the Covid 19 outbreak in 2020. Canada held rates at a historic 0.25% and the USA cut the Federal funds rate to zero in an effort to ease the disruption of the virus as a part of its monetary easing programme.

There are legitimate fears about using negative interest rates to spur an economy. Some of these include: inadvertently creating asset bubbles, high inflation, reduced profitability for the financial sector, excess borrowing and even people putting their money under their mattresses! In some cases, it can even backfire, as was the case in Germany (and other countries) where instead of people saving less, they saved more when interest rates were negative. In addition, if there aren’t a lot of assets, and everyone is chasing the same investments for e.g., real estate, or stocks, then the price will keep increasing and eventually it will create a bubble. No one likes when bubbles burst, as they have far reaching consequences even for people who are not directly invested in those assets.

Excess borrowing can be dangerous, as it may encourage people to borrow far above their ability to service their loans, and eventually they will default. Too many defaults can take you right back to a crisis similar to the Sub-Prime crisis of 2008. On the other hand, while banks are expected to lend money in this type of environment, banks need deposits in order to lend. Therefore, if people really put their money under their mattresses, well maybe not literally, but if they hoard the cash, or decide not to put it in the bank, it could create challenges for banks to find money to lend.

While negative interest rates were used as recently as 2020 in parts of Europe, at the moment, they seem to be a distant memory, as the major Central Banks of the world, including Jamaica, have been steadily increasing interest rates. If external forces such as the war in the Ukraine persist, it is likely that supply issues will continue to place upward pressures on prices. This situation is not likely to last indefinitely, and it is still important to understand one of the tools used to stimulate economies. This is especially important since the side effects of high inflation and war are economic pressures, and as countries enter into recessions, Central Banks may have to dust off the playbooks on negative interest rates.

Lisa Minto is the Assistant Vice-President, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

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