You might have heard the term 'negative interest rates', but what do they actually mean? And how do negative interest rates affect the economy? Here's everything you need to know about negative interest rates.
What are negative interest rates?
Negative interest rates are essentially savings interest rates below zero. With negative interest rates, individuals and banks are charged money for holding onto savings rather than be paid interest. Interest rates are set by the central bank of any given country. Negative rates boost the economy by encouraging consumers and banks to take more risk through borrowing and lending money. This measure is taken to encourage lending and spending and boost the economy.
What causes negative interest rates?
To put it simply, generally a struggling economy. Implementing a negative interest rate takes an incentive approach—in short, it incentivizes and cools down overheated economies and keeps inflation under control.
In Canada, the previous governor of the central bank said that interest rates would remain at a historic low of 0.25 percent set in March 2020. The Federal Reserve in the United States also cut the federal funds rate twice in 2020. If interest rates are lowered further to help the North American economies, rates would drop below zero (meaning the interest rate would be negative).Get started with Wealthsimple Trade. Sign up today and start building your portfolio.
Will negative interest rates happen in Canada?
First of all, negative interest rates have never happened in Canada or the United States. That doesn’t rule out the possibility of them being introduced in North America. Negative interest rates are controversial, but countries such as Switzerland, Denmark and Japan have already implemented negative interest rates.
Examples of countries with negative interest rates
Sweden paved the way for negative interest rates in 2009 when it cut its deposit rate to -0.25 percent. It was meant to jolt a stagnant economy and encourage banks to lend. In the past, the Eurozone, Switzerland, Denmark, Sweden and Japan have allowed rates to fall below zero.
In 2020, the following countries’ around the world had negative interest rates below zero:
Japan: - 0.10
The Bank of Japan (BOJ) chose to adopt a negative interest rate in January 2016 to shake off a yen spike from hurting an export-reliant economy. It charges 0.1 percent interest on a portion of excess reserves financial institutions park with the BOJ.
Denmark: - 0.60
The benchmark interest rate first went below zero in mid-2012 in Denmark and the central bank uses monetary policy to keep the krone pegged to the euro. The rates may not go positive until well into the next decade.
Switzerland: - 0.75
GDP growth prediction for 2020 was meant to be between 1.5% to 2%, but now the government expects that will not happen due to the coronavirus pandemic. Switzerland has kept the same interest rate over the last five years.
Pros and Cons of Negative Interest Rates
The hope is that people borrow and invest to shock the economy with negative interest rates. You’ll find the pros and cons of negative interest rates and implications, both good and bad. Let’s go over both.
Two major pros (in favor of negative interest rates) surface regarding negative interest rates. Here they are:
The incentive for banks: The negative interest rate is meant to be an incentive for banks or other lenders, like mortgage lenders, to lend during a period that they’d rather hold onto funds. In turn, banks may drive borrowing costs lower.
Offers help to borrowers: Helps borrowers whose economies still struggle, years after the 2008 financial crisis.
In the case of negative interest rates, you can unearth a few more cons than pros:
They could backfire: Instead of “hoarding” the money, the hope is that banks lend to people and businesses to spur economic growth. However, because it’s less profitable, banks could actually reduce lending. Negative interest rates squeeze profit margins for banks, which means there’s no incentive to banks to lend, resulting in reduced lending.
No incentive: If consumers get charged interest to hold money in their bank account, they might choose to withdraw their money from banks because there’s no incentive to keep it there.
The possibility of a real estate bubble: Negative interest rates could also create a dangerous real estate bubble. The consequences can be disastrous when they burst. It’s now possible to borrow at less than one percent. This below-zero percent environment has become extremely difficult for banks. Although they try to limit benefit from negative rates for borrowers with a
Lower returns on pension funds: Consumers can see lower returns on pension funds (defined contribution schemes) and life insurance.
Could push people into excess borrowing: Negative interest rates could push people into excess borrowing because it’s cheap and lead them into loans they can’t afford.
Could be counterproductive: The lower the interest rate, the more individuals save, which is counterproductive because it doesn’t increase household consumption — this was noted in Germany and other countries.
Corporations’ approaches change: Excess liquidity is penalized, which leads to a disincentive for corporates to build up reserves of liquidity.
Government funding changes: Negative interest rates could have an impact on government funding.
Inflation issues: It could lead to runaway inflation.
GDP could go down: None of the economies mentioned (Japan, for example) has been able to jump-start enough growth to get out of negative interest rates.
Stock market effects: The financial sector of the stock market would take a hit.
So, what do these pros and cons all mean? People stop spending, demand declines, prices for goods and services fall and people wait for even lower prices before spending, and that can be very hard to break. Negative rates fight deflation by making it more costly to hold onto money, incentivising spending.
What negative interest rates mean for consumers
What do negative interest rates mean for consumers? Here are the basics.
1. You might be inclined to save money.
Savers might hoard cash rather than pay the banks to hold money. In short, you would earn money when you borrow and spend money to keep your money in a bank account.
2. You might see a bump in fees for loans.
This refers to a bump in fees for loans, including home mortgages. Banks could charge customers or pass on fees to consumers.
3. It could affect your investments, including traditionally “safer” bonds.
The bond market could take a hit, and if you’re looking for a higher yield, it could create bubbles in the stock market or in real estate if many other investors do the same thing. Investment firms, take note.
4. Treasuries could be affected.
Safe-haven Treasures could have little to no yield, nor would investment-grade corporate bonds. You may want to put your money in lower-risk stocks like utilities or consumer staples or longer-dated Treasuries or REITs.
5. You may change your investment strategy to incorporate physical assets.Get started with Wealthsimple Trade. Sign up today and start building your portfolio.
Are negative interest rates a good idea?
Low rates are often a sign of a struggling economy. When rates decrease, people are more likely to stimulate the economy by taking out loans and swiping their credit cards. There’s evidence that negative interest rates may not boost flagging economies, hurt banks, savers and companies in the long run. The reality is that the banking system was built on positive interest rates.
It can be extremely difficult to get out of negative interest rates and the global financial system could get stuck. Right now, Europe and Japan are stuck at negative rates, which continues to trouble the banking system in Europe.
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