Why Negative Rates Could Spark Recession

Negative Interest Rates – Overview, Effects on Economy, and Risks

Why Negative Rates Could Spark Recession

Negative interest rates are used by central banks to increase borrowing in times of economic recession.

By offering a negative interest rate, the central bankFederal Reserve (The Fed)The Federal Reserve is the central bank of the United States and is the financial authority behind the world’s largest free market economy.

decreases the overall economy-wide cost of borrowing, aiming to increase economic activity through increased investment and consumption spending.

Negative interest rates are a monetary policyMonetary PolicyMonetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to tool and essentially imply that banks (lenders) will pay interest to borrowers for borrowing money and will collect interest on savings.

Negative Interest Rates – Effect on the Economy

The following diagram shows the channels through which negative interest rates affect the economy (theoretically):

The overnight rateOvernight RateThe overnight rate refers to the interest rate that depository institutions (e.g., banks or credit unions) charge each other for overnight lending.

Note that the overnight rate is called something different in different countries. is the rate at which the central bank lends to commercial banks.

At a negative overnight rate, commercial banks are encouraged to borrow more as they are paid interest on their borrowings.

The negative overnight rate incentivizes banks to lend more. Similarly, consumers and companies are attracted by the unusually low cost of borrowing – wherein they get paid to borrow money – resulting in higher investment and consumption spending.

Companies also borrow money to improve their cash balances at negative interest rates.

The lower interest rate also influences the exchange rate, devaluing the currency and increasing the demand for domestic goods in foreign markets, i.e., exports.

Increased borrowing and spending in the economy, in addition to higher exports, lead to an increase in aggregate demandAggregate DemandAggregate demand refers to the total demand for finished goods and services in an economy. It also refers to the demand for the country’s GDP, and the economy takes a step the recessionary phase.

Negative Interest Rates – Effect on Savings and Bonds

Negative interest rates imply that instead of earning interest, deposits and savings will be charged by banks. However, in reality, savers may simply not earn any interest on their savings. The idea is to make saving unattractive and encourage consumers and companies to spend more instead of stockpiling cash.

Bonds that yield negative (or close-to-zero) interest rates are unattractive to investors. In times when the central bank chooses to reduce the overnight rate to zero or below, investors typically look for safer, income-earning securities stocks.

Risks Associated with Negative Interest Rates

Negative interest rates reduce the profit margins of lending institutions and commercial banksCommercial BankA commercial bank is a financial institution that grants loans, accepts deposits, and offers basic financial products such as savings account. Prolonged periods of low or negative interest rates may encourage banks to cease or decrease lending as profitability decreases.

Negative (or low) interest rates mean that foreign investors earn lower returns on their investments, which leads to lower demand for the domestic currency – devaluing the currency and reducing the exchange rate.

Currency devaluations may lead to competition among countries that export similar goods, along with unwanted exchange rate fluctuations.

Practical Examples

To protect the domestic export industry from an increase in the exchange rate, the Japanese central bank reduced the interest rate in 2016 and announced a 0.1% charge on any reserves that commercial banks deposited in the central bank. This is an example of using negative interest rates as a monetary policy tool.

As of October 2019, several European countries including France, Switzerland, Spain, and Denmark also had negative interest rates as a result of the European Central Banks’ monetary policy to combat signs of economic recession and weakness.

With the COVID-19 pandemic, the US Federal Reserve has reduced overnight rates to almost 0.25%, sparking speculation that the interest rate may turn negative over the next few months. The interest rate has been reduced as a result of expansionary monetary policy.

CFI offers the Commercial Banking & Credit Analyst (CBCA)™CBCA™ CertificationThe Commercial Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more. certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Interest Rate RiskInterest Rate RiskInterest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments.
  • Banking FundamentalsBanking FundamentalsBanking fundamentals refer to the concepts and principles relating to the practice of banking. Banking is an industry that deals with credit
  • Loan CovenantLoan CovenantA loan covenant is an agreement stipulating the terms and conditions of loan policies between a borrower and a lender. The agreement gives lenders leeway in providing loan repayments while still protecting their lending position. Similarly, due to the transparency of the regulations, borrowers get clear expectations of
  • Quantitative EasingQuantitative EasingQuantitative easing (QE) is a monetary policy of printing money, that is implemented by the Central Bank to energize the economy. The Central Bank creates

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