What are central banks trying to achieve by lowering interest rates ?
The objective of negative interest rates is no different to conventional interest rate policy, to encourage households, companies and governments to spend rather than save, thereby supporting economic growth.
Negative rates, however, have a bit more sting in their tail, since in theory any savers with money in deposit accounts will see the value of their savings slowly nibbled away. A central bank that is cutting rates at a faster pace than global counterparts would also expect its currency to weaken, increasing the competitiveness of its country’s exports.
But the aim to weaken currencies does explain the current race to the bottom for interest rates, as policymakers around the world try to avoid their own currencies strengthening as a result of rate cuts on foreign shores. Even a US Federal Reserve Board member has now touted the idea of negative rates.
The theory of negative interest rates is straightforward, but the practice is not. In a paper money system, households have the option to withdraw balances and store savings in physical form as “cash under the mattress”. This makes life difficult for commercial banks, as they get charged a negative interest rate (effectively a fee) on their deposits held at the central bank but can’t pass this on to retail savers for fear of deposit flight. As a result, negative rates merely act as a tax on bank profitability. In fact, the policy could prove counterproductive if banks respond by raising loan charges or fees, or, even worse, reducing lending.
The Swiss central bank is at the forefront of negative rate policy with a policy rate currently set at -0.75%. So far, banks have not generally passed this on to consumers—the average interest rate on savings accounts (typically used by households) has not fallen below zero. Some Swiss banks have recently announced that they may start charging their wealthiest clients to hold large deposits later this year, although this remains far from mainstream practice. Banks have more flexibility in passing through negative rates to corporate customers because it is impractical, if not impossible, for companies to hold their cash in physical form (they would need much bigger mattresses). This is evidenced by the decline in interest rates paid on the one-month term deposits that are predominantly used by corporations rather than households.
Central bankers are cognisant of the issues that negative rates cause, particularly for the banking sector, but have so far decided that the net impact is positive. At some point interest rates will be so low that the benefits no longer outweigh the shortcomings; this is known as the “reversal rate”. One strategy that attempts to mitigate the impact of negative rates on the financial sector is known as “tiering”. When tiering is applied, commercial banks are only charged negative interest rates on a portion of their reserves held at the central bank, with a higher (or less negative) interest rate being applied to the remaining portion. Tiering is already being employed in Switzerland and Japan. The European Central Bank has publicly stated that it is actively considering the strategy as a future option, which has helped to push down the market’s perceptions of how low eurozone interest rates can go. However, in the case of Japan and Switzerland, tiering has only served to dampen, not remove, the negative impact on bank profitability. One radical solution would be to move to a completely cashless society, which would enable banks to pass negative rates directly on to households without having to fear capital flight. Such an approach would be extremely controversial politically, but as in the case of the “crazy” financial analyst predicting subzero interest rates, nothing should be ruled out in the future.