Over the years, interest rates have been on a steady decline and have remained low in all the major developed countries. The low interest rates, while thought to be temporary fiscal stopgaps, have surprisingly lasted longer than anticipated by developed countries. While the low interest rates were synonymous with the U.S. and Europe (including the Euro area, Switzerland, Sweden, and Denmark), the policy has spread to parts of Asia, where Japan is adopting a more accommodative monetary policy that includes negative policy interest rates. Low long-term interest rates are a reflection of low return on safe assets occasioned by demographic changes, a slowdown in technological progress rate, and increased demand for safe assets comparative to their supply. There was a belief among central banks of the impossibility of interest rates going below zero owing to a reaction by corporates and households converting deposits into cash in a bid to escape devaluation. Such a move, banks believed, would conflate the nominal lower bond with the physical lower bond. However, with low inflation and low aggregate demand given high real rates, central banks have been forced to move their marginal policy rates to the negative as a response to the macroeconomic challenges, which have been made worse by the current COVID-19 pandemic. Negative interest rates may have a positive impact on oil importers and a boon for borrowers, there is an increase in a negative balance of trade and a potential for another global economic depression.
One of the effects of negative interest rates is its potential to reduce nominal and real rate component and boosting aggregate demand. The UK, the Euro area, Japan, Sweden, and Denmark are among the countries that have effected negative interest rates. Under normal economic circumstances, negative interest rates would be untenable given the economic impacts that such a move would have. However, negative rates revamp central banks’ signaling capacity through the removal of the zero lower bound within an environment with low inflation and diminishing equilibrium real rate of interest. Such a move has the potential of reducing the nominal rate and lowering the real rate component. In essence, “a decline in the nominal rate could lower its real rate component, allowing inflation expectations to rise and boosting aggregate demand; however, if both nominal and real interest rates are shifted down, a widening gap leads to deflation pressure” (Jobst and Lin 7). Central banks’ cut of deposit rates lower interbank and other interest rates, thereby allowing banks to not only take greater risks including lending to risky borrowers and facilitating portfolio rebalancing.
Low interest rates have the potential of increasing investment and borrowing among households. The theory behind negative rates hinges on two possibilities that come with going below zero lower bounds. In practice, “the zero bound sets a limit to the domain over which the nominal interest rate can be set” (Ilgmann and Menner 394). Going below zero lower bound (ZLB), therefore, could reduce the cost of borrowing for companies and households thus drive demand for loans and incentivize investment and spending among consumers. The two (investment and spending) when positive, traditionally affect the economic outlook and boost confidence. More importantly, the two have a great influence on household and businesses’ investment and saving decisions resulting in increased demand for locally produced goods and services (Ilgmann and Menner 394). Increased demand negatively affects capital inflows occasioning downward pressure on the exchange rate while supporting external demand.
The second effect of activating negative interest rates is avoiding a liquidity trap. A liquidity trap is “the point at which further monetary injections do not stimulate the economy because people opt to hoard all cash available instead of investing or spending it” (Reinbold and Wen 14). At ZLB, individuals, banks, and corporations hoard the available cash without spending or investing it in the economy. Negative interest rates, therefore, work by steering the economy away from zero velocity. Given the risk and cost of holding money for individuals and banks, interest rates below zero. The idea here is to ensure that individuals and banks do not hoard money at the expense of economic development.
The negative interest rates also increase aggregate demand, stimulate economic growth, and steer economies away from a liquidity trap, and while some countries have had positive results towards the desired effect, others have not. For example, one of the impacts of the zero to negative interest rates has been low oil prices. Over the years, oil prices have seen a steady decline moving from $100 a barrel in 2014 to $30 a barrel in 2016 (Naoyuki and Farhad 1). The situation was made worse in the recent years by the Saudi-Russian oil war that saw oil prices plunging to $21.65 a barrel (see graph 1) (Blas n.p.; Macrotrends n.p.). The lower oil prices have been a boon to oil-importing countries, which have seen savings in production and supply chain costs. Given that oil is the main energy provider in production inputs, oil importers enjoy “cheaper input prices for production, which is good news for suppliers and manufacturers of commodities” (Naoyuki and Farhad 9). On the other hand, the low oil prices coupled with negative rates create both fiscal and monetary challenges for major economies. Oil exporters, in this case, have to contend with challenges in fiscal balances and exchange rates. Lower inflation rates experienced in the developed and oil-exporting countries due to low oil prices (occasioned by low demand and oversupply of oil) greatly reduce the effectiveness of the low interest rates and economic activities in these countries. Thus, while spurring production among oil-importing nations, the low oil prices delay the speed of normalization of the Federal Reserve’s monetary policy.
Graph 1. oil price (per barrel) 2013-2020. Source: (Macrotrends n.p.)
Negative interests have been part of the cause of slowing global trade. Countries across the world seem to be implementing negative interest rates, as most of them continue to cut their interest rates, a fact that has impacted global trade, but not adequately. Despite the measures, economists forecast that global trade will continue on a declining path. Since the beginning of the implementation of the negative interests in 2015, the World Trade Organization (WTO) has been adjusting its trade forecasts. While the forecast for 2016 had put global trade growth at 2.8 percent, in light of the measures, WTO adjusted its forecast downwards to 1.7 percent (Hannon and Mauldin n.p.). Subsequently, WTO also adjusted the 2017 forecast estimating its global growth to be between 1.8 percent to 3.1 percent down from the first projected 3.6 percent growth (Hannon and Mauldin n.p.). The slowdown in global trade growth and negative adjustments of projections happen despite central banks’ cutting of the interest rates. Negative interest rates thus deal a blow to global trade through the confidence cost of the low rates. Data from OECD shows that there has been a constant decline in the global business confidence index of OECD countries between 2010 and 2018, with projections showing even lower confidence beyond 2020 (OECD n.p.). From the data, the low interest rates are indeed harming global trade.
the aforementioned negative impact of the negative impact of negative interest rates on global trade, the situation is made worse by the current COVID-19 pandemic. At the beginning of 2020, the low interest rates had already had a great impact on global economic growth. Although growth was tepid, there was a positive outlook. With the virus hitting the globe, however, estimates indicate that the pandemic has the potential of trimming global economic growth by 2% a month (Jackson et al. 1). Moreover, there are fears that the already shrinking global trade due to negative interest rates may shrink by a further 13% to 32% depending on the depth and extent of the global economic downturn (Jackson et al. 1). Exporting countries including Italy, Canada, Japan, and Mexico among others will perhaps be most affected by the virus given their reliance on exports, which have currently been heavily curtailed by the pandemic. China’s role as the foremost manufacturing hub and the origin of the virus exacerbates the situation since, “production declines in China have spillover effects around the world given China’s role in producing computers, electronics, pharmaceuticals, and transport equipment, and as a primary source of demand for many commodities” (Jackson et al. 37). travel bans and quarantines, which will continue to take a heavy toll across global economies, are likely to worsen the situation. There are already projections of economic recessions across Asia (Arnold and Valentina n.p.). The pandemic, therefore, has worsened an already struggling global economy with low interest rates.
Away from the pandemic is the negative effect of negative interest rates on banks’ profitability. Of the two reasons for implementing negative interest rates, one is to avoid a liquidity trap. central banks impose a cost on banks with excess reserves to ensure economies do not fall into the trap (Reinbold and Wen 14). Charging banks for the reserves shrink their net interest margins given than most banks may be reluctant to extend the negative deposit rates onto their customers as a way of avoiding the destruction of their customer base and the ensuing decline in profitability. Therefore, low to negative rates dent banks’ profitability. Economists argue that compressed long-term interest rates correspondingly diminish profit margins on the standard banking maturity transformation of short-term borrowing and lending at longer-term (Reinbold and Wen 14). While most lenders have been reluctant to pass the cost to their customers, it is only a matter of time before they budge to pressure and pass the cost to their customers. Worse is that the influence on profitability becomes more severe over time, as short-term advantages including lower rates of loan defaults decrease. Yet, banks have been reluctant to pass the increased cost to customers fearing the ensuing backlash from both customers and the central banks. As such, the financial institutions have devised different ways of making up for the loss in profit margins by increasing the cost of products for customers. Customers have also had to pay for the reduced profit margins through poor quality services as banks implement other cost-cutting measures that include laying off staff.
Related to decreased bank profitability is negative interest rates’ negative effects on financial markets. As a norm, money market funds invest in cash-equivalent assets including high-rated short-term corporate and government debt. The practice allows the funds to preserve capital and extend liquidity to investors through the payment of some little positive return. The funds purpose to skirt reductions in net asset values—an aim that may be utile in the presence of negative market rates, especially for a long time. Such long-term negative rates can prompt huge outflows and closures and a reduction of liquidity within vital areas of the financial system.
Negative interest rates also increase excessive risk-taking in the financial markets. Traditionally, finance markets and funds look for higher yields and leverage; longer periods of interest rates, therefore, increase borrowing attractiveness. The effect is increased financial stability risk as well as the risk of creating bubbles. Excessive risk-taking among investors relates to inefficient capital allocation in addition to leaving investors with much higher risks than anticipated especially in the acquisition of risky assets.
While negative interest rates increase risk among investors, it disincentivizes governments to reduce their debts. Negative interest rates mean that governments do not feel any pressure to reduces their debts. On the contrary, the negative interest rates encourage governments to borrow more with no implementation of fiscal discipline. An example of this is the Greek and Eurozone crisis, during which governments went on a spiral debt accumulation spree (Kouretas 393). Negative interest rates essentially paint a picture of a flatter debt service ratio, which then misleads governments of debt sustainability. The low to negative interest rates were an anesthetic to the governments in the Eurozone leading to slow fiscal and structural reforms (Kouretas 393). The view of manageable debt ratios and lack of fiscal discipline eventually plunged the countries into a crisis that had a spiral effect throughout the global financial markets and trade.
At their core, negative interest rates purpose to combat deflation by encouraging households/individuals and businesses to borrow and spend money. Additionally, the low interest rates aim at avoidance of the liquidity trap, where people and businesses hoard money without investing it to spur economic growth. By lowering the rates central banks hope to see changes in aggregate demand, and in times of recession, reverse economic downtown. Within the past recessions, economies across the world have been keen using negative rates to spur their economies with generally lukewarm if not negative results. Among the results has been a reduction in oil prices that has benefitted oil importers, while causing a negative balance of trade for exporters. The negative rates have also been responsible for the slowing global trade and have been worsened by the COVI-19 pandemic, reduction in bank profitability, negative effect on the financial markets, excessive risk-taking, and disincentive for government debt reduction. Generally, all the impacts are detrimental to economic growth in the long term. The negative impacts, therefore, call for alternative fiscal and monetary policies that can spur economic growth through an increase of aggregate demand, while at the same time spurring global trade.
Arnold, Martin, A. and Valentina, Romei. “European Factory Output Plummets as Covid-19 Shutdown Bites.” Financial Times, 2020. https://www.ft.com/content/8646c0ee-8fba-4e4c-a047-cf445ff41cf6.
Blas, Javier. “Trump’s Oil Deal: The Inside Story of how the Saudi-Russia Price War Ended.” Fortune, https://fortune.com/2020/04/14/trump-oil-deal-inside-story-saudi-arabia-russia-price-war-ended/.
Hannon, Paul and Mauldin, William. “World Trade Set for Slowest Yearly Growth since Global Financial Crisis.” The Wall Street Journal, 2016, https://www.wsj.com/articles/world-trade-seen-growing-at-weakest-pace-since-financial-crises-1474965904.
Ilgmann Cordelius and Menner,Martin. “Negative Nominal Interest Rates: History and Current Proposals.” International Economics and Economic Policy, vol. 8, no. 4, pp. 383-405, https://www.researchgate.net/publication/225701604_Negative_Nominal_Interest_Rates_History_and_Current_Proposals.
Jackson, James, K. et al. Global Economic Effects of COVID-19. Congressional Research Service, 2020. https://fas.org/sgp/crs/row/R46270.pdf.
Jobst, Andreas and Lin, Huidan. Negative Interest Rate Policy (NIRP): Implications for Monetary Transmission and Bank Profitability in the Euro Area. IMF, 2016, https://www.imf.org/external/pubs/ft/wp/2016/wp16172.pdf.
Kouretas, Georgios, P. “The Greek Crisis: Cause and Implications.” Panoeconomicus, vol. 4, 2010, pp. 391-404, https://www.researchgate.net/publication/49592092_The_Greek_Crisis_Causes_and_Implications.
Macrotrends. Crude Oil Prices. Macrotrends, https://www.macrotrends.net/1369/crude-oil-price-history-chart
Reinbold, Brian and Wen Yi. “Looking for the Positives in Negative Interest Rates.” The Regional Economist, 2017, https://www.stlouisfed.org/~/media/publications/regional-economist/2017/fourth_quarter_2017/pos_neg.pdf.
Tett, Gillian. “The Downside of Negative Interest Rates.” Financial Times, https://www.ft.com/content/7efcedb4.