What Are Negative Interest Rates ?
The Bank of Japan has recently decided that it will cut its rate below the zero percent mark. Bank of Canada has also hinted that it may also join the Bank of Japan in this extreme step and drop its interest rates below zero as well. However, most average people in the world are dumbfounded at the concept of negative interest rates. Nobody really understands what they are and how they might help! In this article, we will explain the concept of negative interest rates in detail.
What is A Negative Interest Rate ?
A negative interest rate is a strange scenario in which theoretically banks will have to pay their borrowers negative interest. It is a strange system wherein borrowing money is a financially wiser thing to do than saving it. Savers will lose money when they deposit it in a bank. Then this same money will be transferred to the borrowers.
This idea is very difficult to understand given the fact that everything associated with it looks bizarre!
Bizarre Scenarios to Negative Interest Rates
The visualization of these bizarre scenarios is what makes this scenario so intriguing. Most people, even experts, have a hard time getting their heads around what a negative interest rates world would look like.
Interest Rates are Like Gravity
Warren Buffet once famously stated that interest rates are like gravity! In reality they truly are like gravity for the financial world. If the interest rates are lower, then the valuation of investments starts to go up. All values go higher regardless of asset class. Stocks, bonds, gold and everything else will go up. The difference is that some assets will go up more than others.
At the same time if interest rates are high, all asset classes start collapsing in value. The proof of this can be obtained by collecting data from the period when Paul Volcker raised interest rates close to 20%.
People know the effect of high interest rates and low interest rates. However, no one is aware about the effect of negative interest rates. At most, it was assumed that negative interest rate would be a temporary phenomenon. However, it seems like negative interest rates will prevail in the long term. How exactly will it affect the economy? This is a question that no-one can answer with any degree of accuracy.
Interest Rates Already Near Zero
Apart from Japan and Canada, many more countries are likely to follow the negative interest rate route. This is because the economy of the world was shaken by the 2008 crisis. All countries were on the verge of bankruptcy.
To make sure that their economy survives, almost every economy reduced their interest rate. This ended up temporarily boosting local economies. However, after a period of time, these countries once again have faltering economies. But now the problem is that they do not have much room to cut interest rates. Interest rates are already close to zero! Economics call this the “zero bound limit”.
Nations and central banks have never ventured into the unchartered territory of negative interest rates. This is an experiment and the world is waiting intently to observe the results. If economic fundamentals are to be believed, the results are unlikely to be any good.
Average Customers Do Not Get the Benefit
Another conjecture regarding the negative interest rate theory is that end consumers would not be subject to negative interest rates. Negative interest rates will be applicable to interbank lending between the central bank and other commercial banks. This does seem to be a lot more plausible than the scenario explained above.
So end consumers may have to pay interest rates that are a lot lower than they paid earlier. In some cases, customers may not be subject to interest rates at all! However, experts rubbish the possibility that negative interest rates can ever prevail at the retail level for a prolonged period of time.
Other experts argue that this is giving special treatment to the banks while leaving the retail borrower and depositor out of a good deal. There are several sides to this argument. However, all we know till now are conjectures. When Bank of Japan does implement its negative interest rate policy, the world will get its first glimpse of what this strange world would look like.
- Fundamental Rules of Corporate Finance
- Present and Future Value of Money
- Net Present Value Calculations
- Opportunity Cost of Capital
- Valuing Cash Flows in Different Periods
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