What Negative Interest Rates Mean for Investors
Most people are familiar with the risks of inflation, where the value of a currency plummets and everything becomes more expensive. In places like Venezuela, these issues have become so severe that there’s a black market for dollars as a secondary currency for exchange. Post-war Germany and Argentina are two other examples of inflationary pressure that sent consumer prices soaring and hurt consumer pocketbooks in a big way.
Deflation is a much harder concept for people to understand – that is, when the appreciation of a currency becomes a problem. In layman’s terms, deflation causes people and businesses to hoard cash rather than spending and investing it, which reduces demand for products and services and puts downward pressure on prices. Lower prices can lead to reduced profits and less economic growth, which in turn leads consumers to hoard even more cash.
In this article, we’ll take a look at one unusual way to beat deflation that’s being increasingly employed by central banks around the world since the 2008 economic crisis.
Negative Interest Rates
Interest rates are the single most important monetary policy tool used by central banks to influence inflation throughout an economy.
A central bank attempts to combat deflation by reducing interest rates in order to encourage consumers and businesses to spend money and raise prices. In some cases, these conventional monetary policies don’t work and the central bank will lower interest rates into negative territory. The move is designed to incentivize banks to lend money and businesses to spend money rather than pay a fee in order to keep it safe at a bank.
There are many different instances of negative interest rates throughout history, but more recently, these policies have been used to ward off deflation. The European Central Bank introduced its negative interest rate policy in 2014, and in January of 2016, the Bank of Japan unexpectedly did the same, cutting its benchmark rates below zero in a bold move to stimulate its economy and overcome persistent deflationary pressures in its economy.
The graph below illustrates Japan's 10-year government bond yields from 2012 through the present.
Impact on Economy & Markets
The impact of negative interest rates is difficult to quantify since the policy has been used sparingly in the past, but there’s some evidence it might be working.
Banks may be reluctant to pass on the cost of negative interest rates to their customers because doing so may encourage them to move their assets. In these cases, lower interest rates would lower the profits of banks and discourage them from lending to riskier parties. Consumers facing a cost of having cash in the bank may decide to take the money out of the financial system altogether – although that scenario hasn’t materialized yet.
The impact of these policies on the foreign exchange market has been much more favorable. When negative interest rates are in place, investors tend to search for better returns in foreign markets, which sends a currency’s valuation lower. Lower currency valuations help boost exports by making them more attractively priced around the world. The Euro has seen these dynamics with regards to its exchange-rate with the dollar since 2014.
Key Takeaway Points
- Negative interest rates are designed to combat deflation by encouraging people and businesses to borrow and spend money.
- Negative interest rate policies have been implemented a few times in the past, but their effects are difficult to quantify.
- Some economists believe that banks will be reluctant to charge customers, which could hurt the financial system even more.
- Other economists believe that negative interest rates could send capital abroad and ultimately help lower a country’s currency valuation to bolster exports.