Negative rate policy

GS-III: Negative rate policy

Context

A negative rate policy once considered only for economies with chronically low inflation such as Europe and Japan is becoming a more attractive option for some other central banks to counter unwelcome rises in their currencies.

Why have some central banks adopted negative rates?

To battle the global financial crisis triggered by the collapse of Lehman Brothers in 2008, many central banks cut interest rates near zero.
A decade later, interest rates remain low in most countries due to subdued economic growth.
With little room to cut rates further, some major central banks have resorted to unconventional policy measures, including a negative rate policy.
The euro area, Switzerland, Denmark, Sweden and Japan have allowed rates to fall slightly below zero.

How does it work?

Under a negative rate policy, financial institutions are required to pay interest for parking excess reserves with the central bank. That way, central banks penalise financial institutions for holding on to cash in hope of prompting them to boost lending.

What are the pros of negative rates?

Lowers borrowing costs.
Help weaken a country’s currency rate by making it a less attractive investment than that of other currencies.
A weaker currency gives a country’s export a competitive advantage and boosts inflation by pushing up import costs.

What are the cons?

Negative rates put downward pressure on the entire yield curve.
Narrow the margin financial institutions earn from lending.
If prolonged ultra-low rates hurt the health of financial institutions too much, they could hold off on lending and damage the economy.
There are also limits to how deep central banks can push rates into negative territory depositors can avoid being charged negative rates on their bank deposits by choosing to hold physical cash instead.

Source: Indian Express

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