What are negative interest rates and why do they exist? Detailed below is everything one needs to understand about this phenomenon.
Last year, the European Central Bank, the Bank of Japan and central banks of several other smaller European nations decided to take a step in the erstwhile-unexplored direction of negative interest rates.
As a result, benchmark bond yields in these countries have been trading below zero for some time now. This essentially means that if a person was to buy a Swiss, Swedish or German 10-year gilt, he or she would have had to pay interest to the government at the end of the tenure instead of earning it.
But what are negative interest rates and why do they exist? Detailed below is everything one needs to understand about this phenomenon.
What are negative interest rates?
A negative interest rate policy (NIRP) is an uncommonly used monetary policy tool through which the central bank sets nominal interest rates below the theoretical level of zero. Countries like Switzerland, Sweden, Denmark and Japan all have a negative central bank interest rate.
Why do negative interest rates exist?
Simply put, interest rate is lowered by the central bank of a country when it wants to provide a boost to spending and investment in the economy.
During a period of deflation, individuals and institutions alike prefer to hoard money instead of spending or investing it, which leads to a collapse in demand, a fall in prices and a decrease in industrial output. In order to combat this, the central bank would typically opt for a loose monetary policy.
However, if the prevalent deflationary forces are too strong, merely cutting the central bank interest rate to zero will not be enough to battle them. This is when central banks opt for NIRP, which would mean that the central bank and perhaps even individual banks will charge a negative interest rate.
Depositors would have to pay the bank money, instead of receiving interest, for keeping their money with the bank. This incentivizes banks to lend more freely to institutions seeking funds, and to individuals looking to invest in the market or spend their money, instead of paying a fee to protect it.
Which countries typically need negative interest rates?
In order to answer this question, one must understand the difference between nominal and real interest rates and their relationship with each other.
The kind of interest rate that most of us are familiar with is nominal interest rate. It is the measure of what an individual would earn on saving a given amount for a year. For example, if you deposit Rs 1,000 in the bank tomorrow, you will earn Rs 40 at the end of an year’s time, given that the bank pays you a nominal interest rate of 4 percent.
However, real interest rate takes into account the ongoing inflationary trend. It is the measure of what that Rs 1,000 is worth in a year’s time and what one could buy with it.
So if a kilo of apples costs Rs 100 today, they will cost Rs 102 a year from now, considering the 2 percent rate of inflation. So, if the bank pays you an interest rate of 4 percent, then your real interest rate would come to 2 percent.
However, if your bank pays you a nominal interest rate of zero percent when the rate of inflation is 2 percent, your real interest rate will come to -2 percent.
Countries where the rate of inflation is higher than the nominal interest rate would be the ones typically requiring NIRP because real interest rates in those countries would be negative. Currently, India has a central bank interest of 6.25 percent and a rate of inflation of around 2 percent, which makes our real interest rate very high compared to such countries.
Why do investors buy bond with negative yields?
The nature of government bonds is such that they are very low risk and are almost like cash, particularly those being issued by countries with the highest credit ratings.
At times when there is a lot of uncertainty in the market, bonds of these extremely “safe” countries attract a lot of demand, even if investors have to pay a premium to buy them. The investor can always trade the bond in the market to net some return instead of holding it to maturity, which still makes it a positive investment.Sometimes, investors have been known to buy these bonds because they expect stimulus from the central bank, which would drive the prices of these bonds up.