15-Aug-2019: Central Banks find a solution in Negative rate policy.

Some major central banks have resorted to unconventional policy measures, including a negative rate policy. Switzerland, Denmark, Sweden and Japan have allowed rates to fall slightly below zero.

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. The European Central Bank (ECB) introduced negative rates in June 2014, lowering its deposit rate to -0.1% to stimulate the economy. Given rising economic risks, markets expect the ECB to cut the deposit rate, now at -0.4%, in September. The Bank of Japan (BOJ) adopted negative rates in January 2016, mostly to fend off an unwelcome yen spike from hurting an export-reliant economy. It charges 0.1% interest on a portion of excess reserves financial institutions park with the BOJ.

Aside from lowering borrowing costs, advocates of negative rates say they 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.

But negative rates put downward pressure on the entire yield curve and 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.