The Problem with Negative Interest Rate Policy

Negative Interest Rate Policy (NIRP) essentially means discouraging depositors from saving and encouraging banks to lend - by charging on their reserves/deposits.

For example, if you deposit $100 in a bank, you end up with $99 in a year's time (assuming a -1% rate). However, retail depositors are usually not charged negative rates, since banks fear a run on them. These rates are usually charged on the reserves which banks keep with central banks, thereby creating incentives for the banks to lend.

So, why is this bad?

To understand that, we must ask ourselves what is it that this policy is trying to achieve. The answer is the Holy Trinity of - Increased Demand, Demand pulled Inflation, and last, but not the least, Economic Growth.

By charging banks on their reserves, central banks want banks to have no reason not to lend money, and at the same time, give the people no reason to save. In fact, central banks are hoping that banks will love to lend and people would love to borrow and spend money, which would increase demand and get inflation and more importantly, growth on track.

Why is that not happening.? Because:

• Inflation is Low: Remember when your grandmother told you that high inflation is bad for the economy? She was right! That’s because 10% inflation means $100 today, would be worth $90 in a year. This phenomenon, induces two kinds of behavior

1. You either invest your money in a portfolio of assets which you believe will return more than 10%; or
2. You spend that money on things you want to consume today - like cars, TVs, a trip to Greenland etc.

• But, since inflation is low, people are not worried about their cash losing it’s purchasing power, which is why, they are comfortable with hoarding cash.
• Confidence is Lower: Specifically, people are unsure about the coming future and feel that prices may fall more further. Moreover, falling confidence also reflects people’s view of the economy, and their own near term prospects. You spend today, when you feel things will be costlier tomorrow!

1. Now that it’s clear that only real confidence in the economy (which can be argued to come from a steady growth in wages and rising strength in labor markets in general!) can get demand rolling - the key to inflation and growth (at least in developed economies!). Which proves why NIRP is bad, because it fails to generate confidence. It in facts kills confidence, with a bullet known as desperation fired from a gun called helplessness!

Another reason, is the unique conundrum created by the concoction of negative rates and inflation:

• Impact of Negative Inflation on Loans:
• When I borrow $100 @ 2% I have to repay 102 in a year. The bank makes $2 for taking the risk and arranging the capital.
• If inflation is negative, it means that $100 today is worth $102 in year (assuming -2% inflation). Which means, I will end up paying $102.4 - more than I should have. This phenomenon discourages me, and all other borrowers, from repaying the loan, encouraging defaults.
• Impact of Negative Rates:
• Keeping the above argument in mind, if the rates are lowered to close to/below 0, banks don't make enough money for taking the risk they take, which reduces their appetite for giving out fresh loans, especially because now they also know that there is increased possibility of a default.

This is how, negative rates and inflation, combine to actually hamper the flow/creation of credit, choking banks’ balance sheets - which creates further systemic risks as already evident in Europe.

Finally, negative rates force investors to go “yield hunting”, which ends up inflating asset prices - also called asset bubbles lovingly. A lot of these Unicorns today, owe their “unreal” status to NIRP (and ZIRP) as people have been forced to look for crazier avenues.

Therefore NIRP is likely to prove ineffective in solving the problems it promises to solve. However, don’t the judge the central bankers yet. After all, desperate times, call for desperate measures!