When, if ever, should central banks set interest rates negative?

The main aim for the Central bank in an economy is to keep prices stable. They serve people using that currency to preserve the value of it, and they do this through the means of monetary policy, quantitative easing and changing base rates. In this essay, I shall answer the question, ‘When, if ever, is it the right time to make interest rates negative?’, looking at times it was in use by central banks around the world and how it negatively affects commercial banks.

Expansionary monetary policy is the use of quantitative easing and lowering interest rates to achieve a higher price level in their economy. Even if you go in negative interest rates consumption is still increased, an example is Denmark, mortgages reached negative rates(-0.5%) which means that people are effectively paid to buy houses through mortgages in Denmark. These are new waters for the world, but they had a great effect on Denmark, house prices spiked in 2012 with the mortgage rates becoming negative the same year. This shows that even if one lowers interest rates to -10% people would consume more, if they pay less to consume, demand should increase. The negative mortgage rates in Denmark have worked by keeping the economy and inflation rate stable by bringing a spike in consumption, as weak inflation rates and changing savings patterns by consumers and businesses put them in the situation of having to impose these rates in the first place, so the only logical next step was to reduce rates further. In certain situations, for example in the 2008 financial crisis, some Central Banks, such as the European Central Bank had to decrease their base rate close to zero to try stimulating consumption, but with the economy still struggling in the years that followed, the central bank turned the interest rates to zero in 2012 and kept digging after they hit the ground turning the base rate negative in September 2014 at -0.2%. They had to do this to stimulate consumption and increase price levels. There was a lot of uncertainty and very little confidence among consumers and firms due to the crisis, so they needed something to spike the consumption, this proves that, in this time, it was right to make the base rate even lower as the inflation rate went back to a stable percentage, just under 2%.

Banks can be seen as a sort of time travel, where people who save suspend their spending, and people who take out loans consume before they can with their own money. Banks help consumers do this at the price/cost of interest rate. When the base rates turn negative, this is harder for commercial banks to do. With lower interest rates, banks have less income from interest than they normally would, and risk losing investors. They must make the price of loans negative, as seen with Denmark and their mortgage rates, and lower their saving base rate. Even though the fear of losing clients and investors is unfounded, the idea and use of negative interest rates is fairly new, so commercial banks utilising this policy or policies along the same line due to their central banks turning the base rate negative are still acting weary of this. But these banks have a potential solution to this problem they are set, banks are normally dependant on interest income, but they are moving towards a more diversified way of making profit so banks would continue making profit when interest rates have turned negative. Banks move to intermediation activities instead; it is less risky, and they still make a profit. Their profit margins may risk being compressed which could have a knock on effect causing lenders to not be able to lend as much and give out less loans. So, the right time to make interest rates negative depends heavily on the state of the banking system, if banks can afford or are prepared to take some potential losses then central banks are one step closer to being able to turn interest rates negative.

As seen in the rest of the essay, there are many elements to consider for when Central Banks should think to turn interest rates negative, even though negative interest rates stimulate consumption, they create a problem for banking systems, so when making the decision, they have to weigh up the internal factors, this is why the answer to this question is not global, but different for each economy. They could work in one economy and not in another, even though the cause and effect mechanism are similar in each economy, having negative interest rates will work differently for each of them. The central bank may be able to reach their objective of stimulating consumption and keeping a low and stable inflation rate, but the banking system must be in a stable position which can afford to give out loans and have losses some years, if all those boxes are ticked, then the central bank can afford to do it.

By Giorgio Grandi

References:

The Guardian: https://www.theguardian.com/money/2019/aug/13/danish-bank-launches-worlds-first-negative-interest-rate-mortgage

GlobalPropertyGuide: https://www.globalpropertyguide.com/Europe/Denmark/Price-History

Financial Times: https://www.ft.com/content/c85b9792-aad1-11e8-94bd-cba20d67390c

The Economist: https://www.economist.com/special-report/2021/05/06/when-interest-rates-turn-negative