Imagine a bank that charges negative interest. Depositors are charged for placing their money with the bank. The thought sounds crazy. But, in recent years, faced with long periods of low inflation, various central banks have used negative interest rates for the purpose of increasing aggregate demand and inflation.

On Jan 29, the Bank of Japan(BOJ) surprised markets by adopting a negative-rate strategy, cutting its benchmark interest rate to -0.1%. It joins the European Central Bank (ECB) as one of the few central banks which have resorted to negative interest rates.

Commercial banks hold reserves that are not lent out to the bank clients. A small fraction of the total deposits is held internally by the bank or deposited with the central bank. Minimum reserve requirements are established by central banks in order to ensure that the financial institutions will be able to provide clients with cash upon request. However, when a central bank charges a negative interest rate for parking its reserves with them, it is penalizing and charging commercial banks for leaving their reserves with the central bank. They are thus encouraged to lend it out, increasing AD (consumption and investment), spurring demand-pull inflation.

It is an unorthodox method to counter deflation and a rather desperate attempt to hit core inflation of 2% in which the BOJ has failed to achieve the target for extended periods of time. But, the extent of its impact is likely to be minimal.

How much good will it do?

  1. Animal Spirits – Liquidity Trap

In theory, interest rates below zero should reduce borrowing costs for households and firms thus increasing loans. In practice, however, the problem is not that banks are unwilling to lend out the money, it is simply that the market lacks investors willing to borrow money from banks – i.e. it’s a credit demand problem and not a supply issue.

Since the property bubble burst in the 1990s in Japan, corporate savings have been massively rising in Japan. Some have used the term balance-sheet recession to refer to Japan’s crisis. A balance sheet recession occurs when the private sector faced by the burst of a nationwide debt-financed bubble becomes a net saver as it aims to pay off the bad debts it has accumulated during the bubble years. The money supply must be grown in tandem with the number of private debts to successfully raise investment and consumption. Unfortunately, interest rates have reached near zero levels but loans have not picked up, coining the term a liquidity trap. With confidence so low, it is unsure whether the negative rates will truly be a problem-solver for the ageing economy.

  1. Why should you keep your money with the banks if you can keep it under your mattress?

In theory, interest rates below zero should reduce borrowing costs for households and firms thus increasing loans. In practice, however, if banks charge depositors for keeping their money with the banks, cash may go under the mattress.

In layman terms, why should you keep your money with the banks if you can keep it under your mattress since both do not give you a return? In fact, placing it under your mattress is safer since you dun have to spend time actually retrieving money from ATMs and you can spend it anytime with you. In economic terms, it is often referred to as the liquidity-preference theory.

This perceivable danger has yet to surface as most commercial banks have yet to penalize depositors except Julius Baer which began to charge large depositors. But, if banks were to begin to charge for deposits, massive numbers of depositors may decide to extract their deposits, it will become a bank run and pose a systematic threat to the banking system. The BOJ and ECB knows the underlying possible of a bank run thus they should cautiously.

A few key points to note:

  1. Japan was actually experiencing negative real interest rates before the BOJ chose to break the negative barrier. Although nominal interest rates were mildly positive(0.01%), inflation was mildly positive(1%). Nominal IR – Inflation Rate = Real IR
  2. Markets are affected by expectations. QE and negative interest rates are meant to be an unorthodox ‘secret’ weapon that the central bank can use as a ‘last resort’ monetary policy. However, the BOJ has been enacting such monetary easing since the 1990s after the property bubble. By now, market expectations have calibrated themselves to such monetary easing. Its effectiveness will dampened over time as investors become accustomed to the use of QE. Analogically speaking, a ‘secret’ weapon is not so powerful if you keep using it and your enemy starts to anticipate it.