Negative Interest Rate Demystified

Image Credits: eveningreports.nz

Why are we discussing negative interest rates?

Because on 29th January 2016, the Bank of Japan introduced negative interest rate policy. It is an unconventional monetary policy tool which can be used to combat deflationary forces in the economy and increase investments and spending.

The world has been trying to battle deflation since 2008. The United States had kept its interest rates near 0 % for 9 long years before increasing it to 0.25 % in December 2015. The Central Banks of USA, European Union and Japan have also tried other unconventional tools like Quantitative easing to increase economic activity and spur inflation. Read more about Quantitative easing in this article: QE

What is the concept of negative interest?

In usual circumstances, commercial banks can keep deposits with the central bank and earn interest on it. But now, instead of earning interest, they will have to pay interest to park their funds with the central bank. This is called a negative interest rate and has been set at -0.1% by the Central bank of Japan.

The Negative interest rate was adopted to incentivise commercial banks to lend more money to consumers and investors instead of keeping it with the Central bank.

Is it a new idea?

It is not a new idea.  The European Central Bank (ECB) also introduced negative rate in 2014. It charges commercial banks 0.3 % to keep their deposits. Other countries with negative interest rates are:

• Sweden   -0.35%
• Switzerland- -0.75%
• Denmark- -0.65%

Why has it been introduced in Japan?

It was introduced to take the economy of Japan out of the deflationary spiral and attain the central bank’s objective of maintaining inflation at 2%.

When there is deflation in the economy, people postpone their savings and investments.  Thus, the demand for goods and services falls down and it further leads to a decrease in price. This is a deflationary spiral.

Negative interest rate policy is expected to counter stagnation and boost customer spending.

The bank of Japan Governor, Harushiko Kuroda said,  “Through the minus interest rates combined with Quantitative easing, I hope we can support companies and individuals in breaking their deflationary mindset.”

But, the efficacy of the negative interest rate is still in doubt. Europe introduced it last year and it still hasn’t worked for them.