Context -Negative rate policy - once considered only for economies with chronically low inflation such as Europe and Japan - is becoming a more attractive option for some other central banks to counter unwelcome rises in their currencies.

What Is a Negative Interest Rate Policy (NIRP)?

• A negative interest rate policy (NIRP) is an unconventional monetary policy tool employed by a central bank whereby nominal target interest rates are set with a negative value, below the theoretical lower bound of zero percent. A NIRP is a relatively new development (since the 1990s) in monetary policy used to mitigate a financial crisis.

Explaining Negative Interest Rate Policies (NIRPs)

• A negative interest rate means that the central bank (and perhaps private banks) will charge negative interest. Instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe.
• During deflationary periods, people and businesses hoard money instead of spending and investing. The result is a collapse in aggregate demand, which leads to prices falling even further, a slowdown or halt in real production and output, and an increase in unemployment. A loose or expansionary monetary policy is usually employed to deal with such economic stagnation. 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.

The Theory Behind Negative Interest Rate Policy (NIRP)

• Negative interest rates can be considered a last-ditch effort to boost economic growth. Basically, it's put into place when all else (every other type of traditional policy) has proved ineffective and may have failed.
• Theoretically, targeting interest rates below zero will reduce the costs to borrow for companies and households, driving demand for loans and incentivizing investment and consumer spending. Retail banks may choose to internalize the costs associated with negative interest rates by paying them, which will negatively impact profits, rather than passing the costs to small depositors for fear that, otherwise, they will have to move their deposits into cash.

Real World Examples of NIRP

An example of a negative interest rate policy would be to set the key rate at -0.2 percent, such that bank depositors would have to pay two-tenths of a percent on their deposits instead of receiving any sort of positive interest.

• The Swiss government ran a de facto negative interest rate regime in the early 1970s to counter its currency appreciation due to investors fleeing inflation in other parts of the world.
• In 2009 and 2010, Sweden and, in 2012, Denmark used negative interest rates to stem hot money flows into their economies.
• 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.

Though fears that bank customers and banks would move all their money holdingsinto cash (or M1) did not materialize, there is some evidence to suggest that negative interest rates in Europe did cut down interbank loans

WHY HAVE SOME CENTRAL BANKS ADOPTED NEGATIVE RATES?

• To battle the global financial crisis triggered by the collapse of Lehman Brothers in 2008, many central banks cut interest rates near zero. A decade later, interest rates remain low in most countries due to subdued economic growth.
• With little room to cut rates further, some major central banks have resorted to unconventional policy measures, including a negative rate policy. The euro area, Switzerland, Denmark, Sweden and Japan have allowed rates to fall slightly below zero.

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HOW DOES IT WORK?

• 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.

WHAT ARE THE PROS, CONS?

Pros:

• 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.
• A lower interbank rate leads to lower interest payments on loans at all levels of the economy. Businesses can now find cheaper loans to fund their projects, like building a new factory, while households can now afford a bigger home because mortgage rates are lower. This is the objective of lower interest rates -- to spur investment and consumption, catapulting the economy out of a recession
• Imagine instead of paying interest every month for a car loan, instead, the amount that one pays each month is less than the previous month. Or view the scenario from a business’s perspective: now a project that was too expensive to start can easily be financed with much lower interest rates. That is the primary objective of super low rates, spurring investment and thus stimulating the economy.

Cons

• 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.
• Depositors

A negative interest rates world would also cause problems for people who store their money in banks. Usually, if interest rates are high, storing money in a checking or savings account means that the bank will pay the depositor interest for storing their money. A Rs 100 deposit one year may turn into Rs 101 the next, and so on. This incentivizes depositing money, since keeping it in cash form means that the holder is losing out on interest they could be earning. Now, with negative rates, the bank will charge the depositor for storing money with them. That Rs 100 the first year could become Rs 99 the next, and so on. The flipping of rates turns the table on depositors so that they are forced to pay a fee for storing their money in banks.

The obvious consequence of charging depositors for storage means that people are more likely to withdraw their money and keep it in cold, hard cash form. This means less money in banks, and since banks use deposits in order to make loans, this would mean a lower quantity of loans.

• Retirement saving

A negative interest rate would punish people trying to save for retirement. If all of a sudden, a retirement savings account stops paying interest and instead reverses into destroying the value of the account, savers are left with less money than they expected to receive for retirement.

WHAT ARE CENTRAL BANKS DOING TO MITIGATE THE SIDE-EFFECTS?

• The Bank of Japan adopts a tiered system under which it charges 0.1% interest only to a small portion of excess reserves financial institutions deposit with the central bank. It applies a zero or +0.1% interest rate to the rest of the reserves.
• The ECB is also expected to take “mitigating measures”, such as a partial exemption from the charge in the form of tiered deposits rates, if it were to deepen negative rates from the current -0.4%, analysts say.
• But designing such a scheme won’t be easy in a bloc where cash is distributed unevenly among countries. It could even backfire by pushing rates up in certain countries, rather than down. 

But what bank would lend on those terms? Why would a bank pay someone to take the money from their vaults when they can have a higher return by just letting the money sit? This is the problem that economists face, and some clever solutions have been proposed.

• The problem with storing money in a bank while interest rates are negative is that holding cash money is more appealing, since cash money will have a higher return stored under one’s mattress than if kept in a bank. One solution would be to impose a carrying tax on money, or .
• If cash were to be stamped periodically in order to lower its value, then, if the opportunity cost for holding cash were to be higher than depositing in a bank, people would return to giving their money to banks. Deposits grow, so the amount available for banks to loan out grows.
• But keeping track of a dollar’s worth and periodic stamping is difficult to administer. Another way to tax money would be to use a familiar method: inflation. If the central bank were to increase the rate of inflation, the value of all dollars would fall, and suddenly individuals are forced to turn to measures other than cash to maintain the value of their wealth.
• The data on the empirical effects of negative interest rates is few and far between. The side effects of negative rates are apparent in the theoretical sense, yet the benefits could counterbalance them. The Bank of Japan’s recent shift in rates is minor, so the side effects discussed may only impact the economy mildly. But if the move causes a resurgence of the Japanese economy, then it may be time for the FED to seriously consider utilization of negative rates