Do negative interest rates cause inflation?
When interest rates are low – or even negative – financial firms are more likely to charge lower interest rates on loans to customers. Customers will then spend this money on goods and services, which helps boost growth in the economy and inflation.
Negative interest rates should help to stimulate economic activity and stave off inflation. However, some policymakers remain cautious about resorting to them because there are several ways they could backfire. Consider what happens with certain assets like mortgages.
Indeed, negative interest rates also give consumers and businesses an incentive to spend or invest money rather than leave it in their bank accounts, where the value would be eroded by inflation.
Negative real interest rates
If there is a negative real interest rate, it means that the inflation rate is greater than the nominal interest rate. If the Federal funds rate is 2% and the inflation rate is 10%, then the borrower would gain 7.27% of every dollar borrowed per year.
The Fed lowers interest rates in order to stimulate economic growth, as lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and subsequent inflation, reducing purchasing power and undermining the sustainability of the economic expansion.
In a negative interest rate environment, an entire economic zone can be impacted because the nominal interest rate dips below zero. As such, storing cash incurs a fee rather than earning interest, which means that consumers and banks have to pay interest in order to deposit money into an account.
Negative interest rates could squeeze profit margins to a level where risk/reward no longer make sense, resulting in reduced lending. If consumers start being charged interest to hold money in their bank account, there is nothing to stop them withdrawing all their cash and storing in their cupboard under the stairs.
The winners
Unsurprisingly, bond buyers, lenders, and savers all benefit from higher rates in the early days. Bond yields, in particular, typically move higher even before the Fed raises rates, and bond investors can earn more without taking on additional default risk since the economy is still going strong.
The benchmark rate of negative 0.1% is meant to encourage banks to lend more and businesses and consumers to borrow more to spur the economy, the world's third-largest.
Bulgaria, Norway, Sweden and the Eurozone have a bank interest rate of zero. Under a negative rate policy, financial institutions are required to pay interest for putting excess reserves with the central bank.
Is deflation a good thing?
Not only does deflation signal a stagnating economy, it can lead to high unemployment, unaffordable debt repayment, and dismal outcomes for businesses. In the worst cases, deflation can lead an economy into a recession, or even a depression.
Lower interest rates can help economic growth because people have more money to spend. It can also lead to lower inflation, which is when the prices of goods and services go down.
The Swiss National Bank and the Danmarks Nationalbank explicitly introduced NIR to make their respective currencies less attractive and thus to dampen the appreciation pressure.
In January 2024, the progressive think thank Groundwork Collaborative published a report in which it declared that "resounding evidence" shows that high corporate profits were responsible for 53% of inflation in the United States during the second and third quarters of 2023.
The 5 causes of inflation are increase in wages, increase in the price of raw materials, increase in taxes, decline in productivity, increase in money supply. You can read about Inflation in Economy- Types of Inflation, Inflation Remedies, Effect of Inflation in the given link.
The effect on banks and related financial institutions has been a major factor in restraining use of negative interest rates. The Federal Reserve did not introduce negative deposit rates even during its energetic, unconventional efforts to stimulate the economy in 2008-13.
The central bank policy rate in Japan remained at minus 0.1 percent in January 2024.
Economists fear deflation because falling prices lead to lower consumer spending, which is a major component of economic growth. Companies respond to falling prices by slowing down their production, which leads to layoffs and salary reductions. This further lowers demand and prices.
Negative rates fight deflation by making it more costly to hold onto money, incentivising spending. Theoretically, negative interest rates would make it less appealing to keep cash in the bank. But the big problem is instead of earning interest on savings, depositors could be charged a holding fee by the bank.
| Countries | Latest value | Reference |
|---|---|---|
| Finland | 4.08 | Dec / 2023 |
| France | 3.60 | Dec / 2023 |
| Georgia | 11.27 | Dec / 2023 |
| Germany | 4.05 | Dec / 2023 |
Why do banks make more money when interest rates rise?
When interest rates are higher, banks make more money by taking advantage of the greater spread between the interest they pay to their customers and the profits they earn by investing. A bank can earn a full percentage point more than it pays in interest simply by lending out the money at short-term interest rates.
But when the short-term rates the Fed pays rise sufficiently to make its interest expenses greater than its interest earnings, the Fed loses money. It stops sending interest earnings to the Treasury.
Capital-intensive utility companies have higher levels of debt. Their debt level decreases in a low-interest rate environment, helping them pay off dues and book profits. Similarly, low interest rates work wonders for companies involved in the construction business since they reduce the borrowing costs of projects.
One reason for lower interest rates is that expected inflation has fallen. Since the middle of 2010, inflation expectations have moved downward, by about half a percentage point.
Interest rates of zero or less might be a foreign concept in Australia – but they're familiar elsewhere. Negative interest rates are not a new phenomenon in the economic world. Japan, Switzerland, and the Eurozone have experience of negative rates, in some cases going back several years. Take Switzerland, for example.
