For a long time economists believed that nominal interest rates, or the amount of money received for depositing money, were theoretically bounded by zero to the downside. Lately, however, central banks from Europe to Japan have implemented a negative interest rate policy (NIRP) in order to stimulate economic growth. How is this lower bound broken?

Real Rates Can and Have Been Negative

Before addressing how negative interest rates are being employed today, it is worth noting that the real interest rate, which adjusts for inflation and accounts for the true cost of borrowing, can and has been negative before. The real rate is calculated as: real rate = nominal rate - inflation. If the central bank sets the nominal rate at 1% annualized and inflation is 2% a year, the real rate would be effectively negative 1%. For example, $100 put into a bank would grow to $101 after twelve months, but be worth $98.98 in terms of buying power after inflation. In other words, the depositor has lost money by keeping it in the bank.

Negative Nominal Rates

The negative nominal rates that have been in the news as central banks seek to stimulate their sagging economies, affect a very specific rate that only impacts members of the banking or financial system. The central bank's overnight interbank lending rate (examples are LIBOR and EURIBOR) is how much banks charge each other to borrow short-term reserves with the central bank acting as a warehousing facility for any excess reserves that the banking system cannot internally match up. It is important to understand that negative interest rates only apply to a small portion of funds, exceeding a certain amount, held by the central bank on behalf of the financial sector. Moreover, these negative rates do not directly impact most other depositors, who have been used to very low rates of interest for nearly a decade anyhow. (See also, Understanding Negative Rates of Europe's Central Banks.)

The overnight interest rate is the basis for nearly every other interest rate including those on retail bank deposits, certificates of deposit (CDs), mortgages, auto loans and yields on corporate bonds. A negative nominal rate could serve to bring down all of those rates as well. The goal is that depositors would rather spend or lend those funds rather than have their value slowly erode over time. Many see this as a signal of desperation by central bankers who have failed to stabilize macroeconomic activity via traditional monetary policy methods, or even by quantitative easing (QE).

The Bottom Line

Japan now joins the European Central Bank (ECB), Sweden, Switzerland and Denmark in enacting a negative interest rate policy in order to kick-start the economy. The goal is to discourage financial institutions from hoarding cash and instead to lend or invest it. While only specific funds held by the banking sector will be subject to paying negative interest rates, it has the potential to lower interest rates across the board making it easier to borrow money for all. At the same time, such a move to negative rates may imply that central banks are out of ammunition in combating recessionary pressures in the economy and that, if this fails to produce good results, there may not be anything left to do.

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