It’s when central banks resort to unconventional monetary policies and set target interest rates below 0%. So under NIRP, the price of money isn’t zero. It’s less than zero.
The idea is to charge the banks that park their money with their central bank. This means that borrowers are credited with interest rather than paying interest to lenders. Instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank.
In recent years, central banks in Sweden, Denmark, Japan, and the European Union have all adopted NIRP.
The economic theory behind NIRP is that negative interest rates will encourage banks to push money out the door rather than pay a fee to hold it.
As a result, the overall aggregate demand will rise.
How does NIRP work?
Interest rates are one of the main levers that a central bank uses to adjust monetary policy and maintain balance in the economy.
The central raises interest rates to help cushion the economy against inflation because higher rates make borrowing by consumers and businesses more expensive.
It lowers interest rates when the country is facing a recession because it encourages borrowing and spending, which stimulates the economy.
Historically, when you take out a loan, you pay more than the amount originally borrowed because of the interest accrued.
Yet if interest rates are negative, the process reverses itself.
If you take out a loan at a negative interest rate, you don’t pay interest on the amount you borrow. Instead, the lender would pay you.
With negative interest rates, you’d end up paying back less than you borrowed, so you’d earn money in the long run.
If you have a savings account with your bank, you will pay the bank for holding your money.
Those central banks currently pursuing NIRP have only imposed it on commercial banks.
Here’s how NIRP would affect consumers:
- If you put $10,000 into a one-year certificate of deposit at 1% interest, at the end of that year, your initial deposit will be worth only $10,100, earning $100 of additional purchasing power.
- If you put $10,000 into a one-year certificate of deposit at a negative 1% interest rate, at the end of that year, your initial deposit will be worth only $9,900.
Negative rates aren’t a response to a specific economic event.
Instead, central banks use negative rates to encourage those holding cash in short-term government notes to move the funds into other, (hopefully) more productive, parts of the economy.
Because you would lose value to negative deposit rates, NIRP discourages hoarding cash.
It is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe.
Charging people to keep cash in the bank is meant to encourage people to spend their money, which puts money back into the economy.
In theory, negative interest rates encourage people to buy homes, use credit cards, and take out other types of loans. By spending more, people would be helping the economy.
What’s the purpose of NIRP?
NIRP is meant to fight deflation.
In economic downturns, people typically hold onto their money and wait to see some sort of improvement before they start spending again. As a result, deflation can become entrenched in the economy. Deflation is a decrease in the general price level of goods and services.
When people stop or decrease spending, demand declines for goods and services, and people wait for even lower prices before spending.
For example, if you want to buy a TV but think the TV will be cheaper tomorrow, you’ll hold off on the purchase today. Then tomorrow comes, and you think it’ll even be cheaper the next day, so you hold off again. And the next day comes…
This can turn into a vicious cycle that can be very hard to break.
Negative interest rates fight deflation by making it more costly to hold or hoard your money, basically, forcing you to spend (“use it or lose it”).
At the same time, negative interest rates would make it attractive to borrow money, since the bank is paying you to do so
Risks of NIRP
Here are the risks arising from NIRP:
- Negative interest rates (NIRP) force investors and money managers to chase yield (seek a positive return on their capital). This requires taking on higher risk, as higher yields are a direct consequence of the higher risk. Investors could be taking on risks an order of magnitude higher than the yield. This phenomenon is called “yield chasing“.
- To generate fees in a NIRP world, lenders must loan vast sums to marginal borrowers (borrowers who would not qualify for loans in more prudent times). This forces lenders to either forego income from lending or take on enormous risks in lending to marginal borrowers.
- The income once earned by conventional savers has been completely destroyed by NIRP, depriving the economy of a key income stream.
NIRP in the U.S.?
Fed Chairman Jay Powell has gone out of his way to dispel any notion that negative interest rates are under consideration, but the one thing he does not do is affirmatively close the door to using them.
He raises doubts about their efficacy and says they would not be appropriate in the U.S. economy.
NIRP could also wreak havoc with the banking sector and money market funds. Nevertheless, if all other tools fail up to this point, negative interest rates have to be left on the table.
Negative market rates can happen in the U.S., and most likely will happen at some point.
The central bankers would be loath to do it, but they cannot rule it out if the market forces their hand and other policy tools prove inadequate.
Vincent Nyagaka is a Professional Trader, Analyst &. He has been actively engaged in market analysis for the past 7 years. He has a monthly readership of 100,000+ traders and has taught over 1,000 students since 2014. Vincent is also an experienced instructor and public speaker. Checkout Vincent’s Professional Trading Course here.