Earlier this month, the Bank of Japan (BoJ) joined central banks in Sweden, Denmark and Switzerland along with the European Central Bank (ECB) in implementing a negative interest rate policy (NIRP) as a monetary tool. A negative interest rate effectively means that depositors have to pay interest on money hold at a bank rather than receive interest payments. The goal is to encourage lending and investment by penalizing the hoarding of cash in order to stimulate economic growth and stave off deflation. While these negative rates only affect companies that comprise the financial sector, and only directly impact amounts of reserves above some threshold, people fear that eventually negative interest rates will permeate the greater economy. (For more, see also: Japan's Negative Rates Signal Banks Out of Bullets.)
If negative interest rates do, in fact, persist and become commonplace for both firms and individuals alike, there are a number of unintended consequences that might follow.
1. Hoarding of Cash
The purpose of a negative interest rate policy is to penalize the hoarding of money, and to encourage those funds to be lent out, invested or spent instead. Ironically, however, one consequence of negative rates is to hoard physical cash, which has an implicit yield of 0%, rather that submit to pay a fee on deposits at a bank. Hoarding cash can have a deleterious effect on spending by creating deflationary pressure, and could lead to destabilizing bank runs if bank customers withdraw large amounts of cash all at once.
In fact, there is already evidence that Japanese consumers are now purchasing safes to keep cash. The possibility of the same happening in Europe has prompted the ECB to announce that it will be abandoning the €500 bank note, and led others to call for the elimination of the Swiss CHF1,000 note and the $100 bill. Monetary authorities are saying that this "war on cash" is intended to stop money laundering and terrorist financing, but many observers see this as a way to make withdrawing and transporting large amounts of cash more difficult as high-denomination bank notes are phased out of circulation. (For more, see: Why Governments Want to Eliminate Cash.)
2. Changes to Spending Behavior
Many people and companies buy things on credit and wait as long possible to pay those invoices. If cash has a positive yield, this is rational as it can accrue a small amount of compounding interest income in the intervening period. If cash has a negative yield, suddenly the incentive is to flip this behavior on its head. Checks received as payment may be deposited only at the last minute before they are no longer valid.
People may even draft certified bank checks to themselves and then hold them in safety deposit boxes until needed. People may begin to favor pre-paid debit cards or gift cards rather than traditional debit and credit cards. The option to pay a recurring subscription may become less favorable to pay a one-time upfront fee. Similarly, businesses may opt to pre-pay their expenses including leases, bills and vendor invoices.
Businesses and some people may also begin to pre-pay their tax bills instead of waiting until the end of the year. Taxes may even be over-paid in advance, in order to shift the negative fee incurred to the taxing authority, and then receive the overpayment due back at a later time. In fact, in Switzerland this may already be happening as the canton of Zug has urged its citizens to cease pre-payment of taxes and instead wait as long as possible to file.
3. Asset Bubbles as Banks "Pay Your Mortgage"
Many have suggested that low interest rates and quantitative easing have encouraged the formation of asset bubbles as people are able to take advantage of cheap money. If rates are so low as to become negative, this means that borrowers are actually paid to go into debt. Mortgage rates are typically pegged to overnight lending rates such as the Fed Funds Rate, LIBOR or Euribor. If, for example, LIBOR becomes sufficiently negative, it is certainly possible that mortgages could eventually carry negative yields as well. This is bound to hurt profitability for lenders; however, they could still earn a credit spread if the bank borrows from the central bank. For example, the bank could take out a central bank loan at -4% on a mortgage issued at -1%. Here, the "borrower" is still credited 1%, but the bank is able to lock in a 3-point spread. (For related reading, see: Effect of Fed Funds Rate Hikes on the Housing Market.)
If people can receive money by borrowing, it can cause a rush of borrowers to go as deep into debt as possible with little fear of having to service those debts with income. Instead, the financial system could enable a rentier class who earns passive income while the money being borrowed does little for the economy. Worse, the money borrowed can be spent on frivolous or non-productive pursuits and then the borrower simply gets paid to borrow even more.
4. Currency Wars
Denmark and Switzerland first adopted negative rates to deter foreign investors from buying up their currency, which was perceived as a safer haven than the euro during the sovereign debt crisis. Buying up this "safe" currency bids up its the price, potentially hurting exporters and causing economic problems at home. Also, a rational investor in a global economy will prefer to invest in a country with a positive yield rather than a negative one. This will also have the effect of bidding up that currency.
If a country has a mandate for an expansionary monetary policy, foreign inflows of capital which strengthen the domestic currency can undermine this policy. As a result, countries may devalue their currencies through other mechanisms in a race to the bottom to deter such foreign intervention. (For more, see: 3 Reasons Countries Devalue Their Currencies.)
The Bottom Line
Negative interest rates in practice are a very new and uncertain monetary policy tool. While its intention to spur economic growth and prevent recession is certainly valid, policy makers ought to be aware of the unintended consequences that may accompany such an untested policy.