What is negative interest rate policy? How it works?

Interest rate is traditionally assumed to be positive. But in recent times, several advanced country central banks are adopting negative interest rate policy. The US Fed also hinted that it will adopt negative interest rate policy if needed. European Central Bank and Japan have already launched negative interest rate policy. When the central bank adopts a negative interest rate policy, it charges an interest rate if commercial banks lends money through its liquidity facility (in India, it is known as reverse repo).

 What is negative interest rate policy?

A negative interest rate means the central bank charges negative interest on deposits made by commercial banks with the central bank. Here, instead of receiving money on deposits, commercial banks must pay to interest to the central bank. The banks will transfer this negative interest rate to their loan and deposit activities. But it is not necessary that banks will be charging negative interest rate, rather they may charge a small reduced interest rate after the central bank policy.

When negative interest rate policy is adopted? How it works?

The policy is adopted to escape from deflation. During adverse economic conditions households and business people waits for long to see the economy recovering. But this withholding of spending itself will make things worse. Lack of spending will reduce investment and jobs, leading to steep deflation and recession.

Here, the best strategy is to incentivize people to spend. For this, more loans should be given. An extremely low interest rate near to negative interest rate will encourage people to borrow and spend.

But the working of negative interest rate is unique. Negative interest rate policy adopted by central bank doesn’t necessarily mean that negative interest rate for loan takers from commercial banks. Rather they will charge a low and much reduced rate of interest. If the banks are parking their money with the central bank there is negative interest rate. Hence, they will try give it to public. To do this, banks will lower the interest rate further to negligible levels.