What happens when we enter a deflationary spiral? The government deploys monetary policies to infuse cashflow in the economy and boost the spending. Reduction in cash reserve ratio, repo rates, reverse repo rates, increasing loan moratorium are the typical measures taken to infuse capital in the economy and boost spending. However, if deflationary forces are strong enough, simply cutting the central bank’s interest rate to zero may not be sufficient to stimulate borrowing and lending. That’s when certain unconventional ways are adopted to encourage spending.
One such method is to adopt a Negative Interest Rate Policy (NIRP).
Interest rates explained:
Nominal interest rate – Inflation = Real interest rate
Where nominal interest rate is the interest rate quoted on bonds and loans and real interest rate gives the real rate of a bond or loan, by adjusting inflation. A higher real interest rate makes current spending expensive, hence making holding money a lucrative option. Thus higher the real rate of interest, encourage hoarding of cash, which further deteriorates the deflationary situation.
Negative Interest Rates
During deflation the rate of inflation falls and so does the nominal interest rates. Normally nominal interest rates cannot go below 0. When this happens, any further downside in the inflation rate leads to the real interest rate to go up. This in turn discourages spending, thus fueling the deflationary spiral.
To avoid this, countries adopt NIRP, wherein they set a negative nominal interest rate. From mathematical perspective, in the above equation, this mitigates the decrease in inflation rates and hence stabilizes the real interest rate. Now let’s understand its real world implications.
In simple terms, a negative nominal interest rate means that one has to pay interest on deposits, rather than receiving it. This extraordinary monetary policy tool is used to strongly encourage borrowing, spending, and investment rather than hoarding cash, which will lose value to negative deposit rates.
Real life examples
- Switzerland was the first sovereign government to charge a negative interest rate between 1972 and 1978. The country’s central bank imposed a negative interest rate to help stabilize the economy and to prevent its currency from rising too much from foreign investors buying its currency.
- In 2014, the European Central Bank (ECB) instituted a negative interest rate that only applied to bank deposits intended to prevent the Eurozone from falling into a deflationary spiral.
- Sweden in 2009-10, Denmark in 2012, have all used negative interest rate policy to infuse funds in the economy, giving it the necessary boost.
NIRP comes with its own set of problems. Small investors flush out funds from the banking system, paralyzing it further. To counter this, commercial banks generally do not pass on the impact of NIRP to its consumers. They bear a cut in profits, by paying the interest on deposits on their behalf, to meet the larger purpose of boosting the economy. This eventually makes lending expensive and encourages banks to cease lending.
Negative interest rates mean that foreign investors earn lower returns on their investments, which leads to lower demand for the domestic currency. This leads to devaluation of the currency and reducing the exchange rate.
Thus the cons of NIRP outweigh its pros, making it a last resort to check deflation. With interest rates around the world hovering at their all time lows, due to the wrath of Covid-19, one can just wonder whether or not this option can be explored!
