It does sound crazy, for sure.
The European Central Bank doubled down on its negative rate policy last month; banks will now have to pay 0.5% interest simply for depositing much of their spare cash with it. It’s an attempt to make them lend more to kickstart the economy.
Several of Europe’s central banks cut interest rates below zero in 2014, and then Japan followed. By mid-2016, some 500mn people in a quarter of the world’s economies were living with rates in the red.
Unthinkable before the 2008 financial crisis, the idea is to jolt lending, spur inflation and reinvigorate the economy after other options are exhausted.
To battle the global financial crisis triggered by the collapse of Lehman Brothers in 2008, many central banks cut interest rates near zero. A decade later, interest rates remain low in most countries due to subdued economic growth.
With little room to cut rates further, some major central banks have resorted to unconventional policy measures, including a negative rate policy. The euro area, Switzerland, Denmark, Sweden and Japan have allowed rates to fall to slightly below zero, weakening their currencies by encouraging investors to seek higher returns elsewhere.
Under a negative rate policy, financial institutions are required to pay interest for parking excess reserves with the central bank. That way, central banks penalise financial institutions for holding on to cash in the hope of prompting them to boost lending to businesses and consumers.
Aside from lowering borrowing costs, advocates of negative rates say they help weaken a country’s currency by making it a less attractive investment than other currencies. A weaker currency gives a country’s export a competitive advantage and boosts inflation by pushing up import costs.
This is one of US President Donald Trump’s motivations for wanting negative rates on the dollar.
But here’s is the flip side.
There are limits to how deep central banks can push rates into negative territory - depositors can avoid being charged negative rates on their bank deposits by choosing to store actual banknotes instead.
In wider sense, negative interest rates are an act of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans.
If banks make more customers pay to hold their money, cash may go under the mattress or into a safe instead, robbing lenders of a crucial source of funding and perhaps even triggering a bank run.
There is also the possibility that the plunge in long-term interest rates would frighten many consumers into believing that their retirement savings were being eroded, leading them to save more and spend less.
It’s an unorthodox move that has distorted financial markets and triggered complaints that the strategy is backfiring. Negative rates will either mark the start of a new era for central banks, or finally expose the limit of their powers.
But here’s the larger issue: The waning effectiveness of below-zero rates raises hard questions of whether an economy can achieve adequate growth based on its fundamentals.
