Negative interest rate: This is when the central bank sets interest rate to negative (less than Zero). This means the banks and the central banks charge depositors on their deposit. It is an unconventional monetary policy tool that is used by central banks during a period of deflation. Bloomberg explains it as an act of desperation. It is usually used when conventional monetary policies have not made an impact on the economy or rather proved ineffective.
Why negative interest rate?
Central banks decide on using negative interest rate for several reasons such as
During a deflationary period: when people are not spending money but hoarding money, a negative interest rate forces banks to lend money and individuals to invest, spend or lend money because it doesn’t benefit an individual or a corporation to pay a fee to hold their money.
Send investors abroad: negative interest rate can discourage investors from investing in a particular country, if an investor will get better returns abroad, why would they invest in a country that has negative interest? They are more likely to take their money elsewhere. It might sound bad for the economy but it isn’t if an economy is suffering from deflation. When investors start to take their money elsewhere, in the long run, the currency is likely to depreciate. When the country’s currency depreciates, the price of imports will increase thereby combating deflation and enhancing export growth. A typical example can be taken from the ECB, in 2014 a negative interest rate was introduced and since then, the Euro has falling against the dollar by 0.2%. Other economies are adopting the unconventional negative interest monetary policy like Denmark, Sweden, Switzerland and Japan.
How does it affect the banks?
Negative rates can affect banks in different ways
Squeeze bank profit: banks are affected because they may not want to charge customers a fee for holding their money, so they are willing to absorb the cost thereby reducing their profits.