The negative interest rate is becoming a major part of a national and international monetary policy debate.
In the past, it was seen only as conceptual and relegated to university discussions and forums at think-tanks. However, over the past couple years it has been adopted in several countries throughout the world. This is creating ripples throughout the international financial community and is impacting the decision makingprocess of the Federal Reserve here in the United States.
What are negative interest rates?
Interest rates represent the amount of money received for depositing or borrowing money with a financial institution. Central banks use interest rate policy as a way to stimulate or control economic growth. Higher interest rates encourage people to save more money while lower interest rates encourage people to spend and invest more money.
Economists traditionally assumed that the lower bound for interest rates was zero. Negative interest rates could cause disruptions in money markets and they could cause more problems than any possible positive benefits of encouraging more spending, investing, and lending by banks.
However, central banks have a mandate to do all they can to fight deflation. While high inflation can constrain economic growth, deflation can have catastrophic effects on an economy. A deflationary environment can cause an economy to come to a grinding halt, as people hoard money rather than spending or investing. Moving interest rates into negative territory, in theory, could encourage consumer spending to increase and could encourage greater lending by financial institutions.
Where are negative interest rates being used?
Recently, central banks across the globe have decided to put theory to the test, by dropping interest rates into negative territory. These include Switzerland, Denmark, Sweden, the Eurozone, and most recently, Japan. In fact, some European countries have continued dropping rates further into negative territory in response to persistently weak economic conditions.
Could negative interest rates impact the US?
Officials from the US Federal Reserve insist that negative interest rates are not under serious consideration in the United States, but could be an option in extreme economic circumstances.
Janet Yellen, in recent testimony to Congress, commented on the probability of negative interest rates in the United States, when she said: “I am not aware of anything that would prevent us from doing it, but I’m saying we have not fully investigated the legal issues — that still needs to be done.”
She continued by saying: “I do not expect that the [Federal Open Market Committee] is going to be soon in the situation where it’s necessary to cut rates.” The possibility of negative rates is “something that, in light of European experience, we will look at, we should look at — not because we think there is any reason to use it, but to know what could potentially be available.”
Banks Retain Control over Rates
It is important to note that while some interest rates in other countries have dropped into negative territory, this does not necessarily mean that customers of banks in the United States would ever expect to pay to hold deposits in banks. Central banks, including the US Federal Reserve, only have the ability to determine the borrowing costs on very short term loans. As the time period of a bond increases, the interest rate increases. Banks ultimately decide how to incorporate interest rates into their deposit and lending decisions.
Negative interest rate policy is a new and untested method of encouraging behavior in financial markets. We don’t yet know if it will be successful or if it will result in unintended consequences to those countries experimenting with the rates. However, it is important to keep in mind that while central banks can determine the rate of return on very short term borrowing, they cannot dictate how banks decide to respond.