Near-zero rates not doing the trick? Try negative interest rates

Whilst most central banks in the world are flirting with cutting interest rates, last week the Bank of Japan (BoJ) raised rates for the first time in 17 years – leaving its negative interest rate policy behind.

After eight years, the Bank of Japan joins the rest of the world by reinstating a positive rate of interest. But what on earth are negative interest rates, and why would a central bank want to even have them?

Macroeconomics 101

Let’s start off with the basics. The primary mandate of central banks is to maintain price stability over the medium term, typically seen as a 2% rate of inflation. Although high inflation is dangerous for economic stability, a modest rate is seen as a sign of a healthy economy: if consumers know that prices will rise in the future, 2% inflation will encourage them to spend sooner rather than later.

This inflation target is symmetric, meaning that deviations from the desired rate in either direction (less or more than 2%) are equally as undesirable. Macroeconomics 101 will tell you that central banks have different tools that can be used to influence this rate of inflation, mainly in the form of interest rates (aka the price of money).

You can imagine this relationship between a central bank and the economy as one between a doctor and a sick patient: the CB administers different medicines to help the economy. Now, imagine that an economy is battling a recession: loose or expansionary monetary policy needs to be implemented to encourage spending and economic activity. Simply put, this is done by cutting interest rates to make it easier for firms and consumers to access finance.

Japan’s deflation

This is precisely the situation Japan found itself in the 1990s following a string of shocks that plunged the country into a deflation (when the general level of prices falls, rather than rises).

Though falling prices may seem like a welcome development in anyone’s life, deflation is a sticky trap that is extremely difficult to climb out of. When people start to expect falling prices, they postpone their spending indefinitely, resulting in goods stockpiling and profits shrinking, only further fueling deflation (aka. deflationary spiral).

Despite novel attempts to reinvigorate spending, such as setting near-zero rates of interest and introducing a practice known as Quantitative Easing (buying assets by expanding the CB’s balance sheet to essentially “print” electronic money), Japan’s deflation persisted. The country became synonymous with the rare and particularly tenacious form of deflation.

Negative interest rates

Enter the title of this post: negative interest rates. Technically speaking, rate cutting does not need to end when hitting zero: in 2016, one of the BoJ’s main interest rates fell below zero. To understand how this can happen, we first must understand how interest rates work.

In essence, a central bank is the bank to all commercial banks. These commercial banks can both hold deposits and loan money from the CB, depending on their liquidity needs. When setting interest rates, a CB influences the cost for banks to acquire liquidity, which then influences the general level of interest rates in an economy through the process known as the transmission mechanism. In other words, a CB cannot dictate commercial interest rates, only influence them.

As mentioned, interest rates come in two forms: the cost (or rather profit) of depositing and cost of loaning. When cutting rates, the objective is to make it cheaper for commercial banks to obtain funds to encourage them to set lower rates for the general public. Negative interest rates perform the same role as low rates, only dialed up to eleven.

Take the cost of depositing: in a recession, a central bank wants to discourage having idle capital that is not actively participating in any activity. Hence, it can gradually chip away from the profits commercial banks make from holding their deposits at the CB. With negative rates, commercial banks have to pay the central bank to keep their money. Incredible! This is precisely the rate that the BoJ kept negative.

Loan rates can also be negative. The lower the interest rate, the less the lender has to pay in interest fees. With negative interest rates, commercial banks actually receive money for taking a loan, albeit this would most likely come with several caveats. Nevertheless, a good deal to say the least.

Conclusion

Although incredibly interesting and appalling, negative interest rates are a technicality that go often unmentioned in most economics textbooks. Nevertheless, they were a reality that faced Japan as it battled its on-and-off periods of deflation.

Now, something has changed. Inflation in Japan was hesitant to return to its sub-zero lows after prices rose between 2022 and 2023: like in most high-income countries, a hot labour market and other supply-side difficulties have resulted in upwards cost-push price pressures.

After almost two years of above-target inflation, the BoJ finally decided that enough is enough. The last time it rose interest rates Steve Jobs stormed the world with the first iPhone. Now, as the model 16 is slowly preparing to hit shelves, the BoJ has done it again.