The conundrum of the negative interest rate

Interest rates have been around ever since mankind discovered trade and for good reason, it is a convenient way of pricing money and its opportunity cost. In today’s modern society it is an integral part of everyday life as it determines investment profitability and mortgage payments. A central actor with the discourse of interest rates is the central bank. The central bank regulates the rate through the supply of money to the markets. However, recently money markets have witnessed several central banks such as the Danish central bank and most notably the ECB cut its rates below the zero-mark. How is this possible given that it is the price of money? Who would volunteer to lend money only to lose money?

In order to understand the negative interest rate and why it is employed it is necessary first to gain an understanding of monetary policy and how central banks control the short-term interest rate. As mentioned the interest rate is the price of money but more precisely it is the price at which market actors can borrow money. Since the central bank in most countries is vested with the authority to print money it alone determines the amount of money circulating in the system. This means that market actors (banks or ordinary people) are limited to the amount of money the central bank supplies. For example if the demand for money increases without a subsequent increase in supply, money will become more scarce and its price will increase as actors place a higher value in holding it.

So why a negative interest rate? A negative interest rate can have several causes but the most relevant cause in this case is to boost demand. In the aftermath of the Global Recession and the European financial crisis, demand for goods and services across Europe has yet to return to pre-crisis levels. In introducing a negative interest rate, and disincentivising keeping its money in bank deposits, the ECB hopes to encourage businesses and private consumers to borrow money for investments and private consumption. When consumption and investments increase firms expand their production to meet the increase in demand which requires more labour and more people are employed, pushing the economy out of recession. The ECB’s strategy has not been entirely successful and the explanation ties in with the question posed earlier, why would anyone lend money at a loss instead of withdrawing it? The reason European banks have not been subjects of inexorable bank-runs is of pure convenience. Withdrawing huge sums of money and storing them in the mattress entails storage costs that may well overshadow the interest payment. To prevent borrowers from profiting from taking out a loan, banks slap on an extra fee to cover the negative rate.

Alexander Dannerhäll