Zero Lower Bound No More

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Andrew Stiles

For months now, the world’s central banks have been contemplating the use of negative interest rates. This means that central banks lower their target interest rate below 0%.

During times of economic recession, most banks, including the Federal Reserve, and the European Central Bank, lower their interest rates to near-zero values. This is designed to encourage borrowing and keep money moving through the economy; however, consumer confidence in Western Europe has fallen so low that people still won’t borrow, despite record-low interest rates.

Because of this, some central banks have decided that more aggressive measures, such as negative interest rates, need to be implemented to encourage consumption and borrowing. A negative interest rate reverses the traditional relationship between depositor and bank; instead of the depositor receiving interest for keeping their money in the bank, they must now pay interest to the bank to hold their money. The idea is that people will find it more economical to use their money for consumption, investing, and other purposes instead of letting their wealth dwindle away in a bank account.

Few times in modern history has a central bank implemented negative interest rates– one example being Switzerland in the 1970s. For the most part, negative rates are uncharted monetary policy territory.

The brave souls to venture into the world of negative rates thus far are Japan, Sweden, Denmark, Switzerland (again), and the European Central Bank. The rest of the world banks are waiting to see what happens to these lab-rats before taking the plunge.

As for the United States, negative interest rates are becoming a more likely scenario as time goes on. The Fed recently released its 2016 stress test, which assesses the ability of systemically important financial institutions (massive banks on which the economy depends) to withstand economic shocks and other unexpected financial market events. One such scenario was the implementation of negative interest rates. This has lead many investors to speculate that the Fed is seriously considering negative rates as an option for their near-future policies.

So far, the negative interest rate experiment has gone surprisingly well. Banks feared that discouraging deposits would result in depositors running on banks to stuff cash under their mattresses - as was common practice in the US during the Great Depression. In reality, however, the negative rates are performing exactly as policy makers hoped - people are using their money more actively, since there is less incentive to store it in a bank.

Many players in the financial industry are still highly skeptical of negative rates. Huw Van Steenis from JP Morgan Chase & Company recently stated that negative rates are a “dangerous experiment” that has severe long-term consequences for monetary policy.

If, in the following months, negative interest rates don’t prove as disastrous as some fear, then more countries could adopt this policy – the United States’ Federal Reserve is no exception. The question will become not about the impact of dropping rates below zero, but rather, how to raise them back above what economists used to call the “zero lower bound.”