Negative interest environment definition

Negative interest environment definition

What is a negative interest environment? A negative interest rate environment exists when the nominal overnight interest rate for a given economic zone falls below zero percent. This means that banks and other financial institutions would have to pay to keep their excess reserves at the central bank instead of receiving positive interest income.

A negative interest rate policy (NIRP) is an unconventional monetary policy tool in which nominal target interest rates are set at a negative value below the theoretical zero percent lower bound.

The central theses

– A negative interest rate environment exists when overnight interest rates fall below zero percent. In 2009 and 2010, Sweden and 2012 Denmark used negative interest rates to stem hot money flows into their economies. In 2014, the European Central Bank (ECB) introduced a negative interest rate that applies only to bank deposits, designed to prevent the eurozone from falling into a deflationary spiral. In a negative interest rate environment, financial institutions have to pay interest on deposits. Can actually get interest on borrowed money.

The fundamentals of a negative interest rate environment

The impetus for a negative interest rate is to spur economic growth by encouraging banks to lend or invest excess reserves rather than suffer a guaranteed loss. The theory is that when interest rates are below zero, banks, businesses, and households stimulate the economy by spending money instead of saving it. The assumption is that a negative interest rate environment encourages banks to lend more, households to buy more products, and businesses to invest more cash rather than deposit it in the bank.

Because it is logistically difficult and costly to transfer and store large sums of money, some banks may still charge negative interest rates on their deposits. However, when the interest rate is set sufficiently negative, it begins to exceed the cost of storage. Negative interest rate environments are designed to penalize banks for holding on to cash instead of lending. They should, at least in theory, make it cheaper for businesses and households to borrow, borrow more, and pump more money into the economy.

Risks of a negative interest rate environment

A negative interest rate environment poses some risks. If banks penalize households for saving, this may not necessarily encourage retail customers to spend more money. Instead, they may be hoarding cash at home. The introduction of a negative interest rate environment may even lead to a cash run, prompting households to pull their cash out of the bank to avoid paying negative interest rates on savings.

Banks that want to avoid cash runs can forgo the comparatively small deposits of household savers. Instead, they are applying negative interest rates to the large balances of pension funds, investment firms and other corporate customers. This encourages corporate savers to invest in bonds and other instruments that offer better returns while protecting the bank and the economy from the negative effects of a cash run.

Examples of negative interest rate environments

The Swiss government introduced a de facto negative interest rate regime in the early 1970s to counter its currency appreciation as investors fled inflation in other parts of the world.

Recent examples of a negative interest rate environment include the European Central Bank (ECB), which cut its interest rates below zero in 2014. A year and a half later, in 2016, the Bank of Japan also adopted negative interest rates. The central banks of Sweden, Denmark and Switzerland also switched to negative interest rates from 2009 to 2012. These countries used negative interest rates to stem hot money flows into their economies and maintain control over their exchange rates while foreign capital flowed into those economies.

Central banks in these countries have created a negative interest rate environment to stop deflation, which they fear could quickly spiral out of control, devaluing currencies and hurting economic progress since the Great Recession. However, negative interest rates have been low so far.

Central banks have been reluctant to lower negative interest rates too far below zero because the practice of creating negative interest rate environments began only recently, when the ECB became the first major financial institution to create such an environment. ECB charges banks 0, 4 percent interest to hold cash overnight. The Bank of Japan charges 0, 10 percent interest for holding cash overnight, and the Swiss central bank charges 0, 75 percent interest for holding cash.

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