What is a Negative Interest Rate?
Negative interest rates refer to a scenario where the interest rate on a financial instrument drops below zero. This implies that bond purchasers are now obligated to pay interest to the bond issuer. Similarly, depositors are required to pay interest to banks to keep their money in the bank. Countries that have implemented negative interest rates have experienced significant changes. Banks are now forced to bear some of the costs of funds due to the tax imposed by negative interest rates in the federal funds market. To retain their depositors, banks have had to adjust and accept lower deposit rates or charge them to hold their money. Previously, saving for future spending was considered a wise financial practice, but it is now viewed as poor financial management in such an environment.
Once again, economic experts are sounding the alarm over an upcoming US recession. According to CNN, a US recession is predicted to occur in the latter half of 2023. JPMorgan CEO, Jamie Dimon, has warned of potential economic danger just beyond the horizon, stating that he would welcome a mild recession given the risks ahead. Similarly, billionaire investor Stan Druckenmiller predicted a hard landing at the Sohn Investment Conference and urged people to be open-minded to the possibility of something terrible happening.
With this in mind, it is always useful to discuss the several tools fiscal and monetary policy can use to tackle this crisis. Implementing a negative interest rate can be a possible solution for US recessionary worries.
One of the most prominent theories of interest rates has been that negative interest rates have a negative relationship with economic growth targets because of cash. The theory goes that when interest rates go negative, there is a desire for assets to be withdrawn from banks and held as hard cash. This is because money has zero nominal rates of return, so no wealth is lost for the owner, who would originally have had to pay to hold a deposit within a commercial bank. So if negative interest rates were to go negative, there is no theoretical guarantee that consumption and investment would grow. This is why banks are wary of implementing deposits to consumers because a lack of investments and consumption can threaten system liquidity and stability Banks are wary of deposits partly because holding deposits through cash can threaten system liquidity and stability.
This has led to several debates on implementing negative interest rates in environments where paper currency is the primary medium of economic transactions. Buiter explored whether negative interest rates can be implemented on paper currency. The research refers to experiments during the great depression where stamp taxes were implemented (a piece of paper currency could only be used if it was stamped to reflect that a tax had been paid). Mankiw offered an alternative perspective where currency could be taxed based on a lottery system where the winning numbers would make the corresponding currency worthless.
However, most developed nations have implemented negative interest rates with substantial degrees of success because daily cash flows are digital, meaning that holding currency as large sums of cash is inconvenient for most people. For example, the citizens of Sweden have largely abandoned physical cash and conduct their transactions through digital means such as cards and mobile payment apps (Riksbank, 2019). As a result, even when negative interest rates were first placed in 2015 by the Riksbank, they did not experience severe cash holdings.
In a general EU context, the results are similar, although dependent on the financial systems within each nation. Linares Zegarra and Willson (2021) examined the impact of negative interest rates on cash flows. Results showed that countries experienced an overall increase in cash flows when negative interest rates were implemented. However, countries with low levels of financial intermediation, such as low lending and deposit-taking activity, had higher cash flow levels than nations with strong levels of financial intermediation. The explanation is that because intermediation helps lower the cost of information and transactions, savers could achieve better diversification and liquidity of their funds than simply holding cash during the negative interest rate regime.