Negative Interest Rate Policy (NIRP)

In recent years, the a few central banks such as in Denmark, Sweden, Switzerland, European Union (EU) and recently in Japan have implemented the Negative Interest Rate Policy (NIRP) regimes in their jurisdictions in an attempt to raise economic growth and counter deflationary conditions. In this article, we are taking basic to advanced questions related to NIRP regime and its implications.

Questions and Answers

What is deflation? How it is different from inflation and Disinflation?

While inflation is rise in general price level of goods and services; deflation is fall in general price level of goods and services. Disinflation is a slowdown in inflation rate.

In inflation, the real value of money decreases while in deflation real value of money increases. Thus, while one can buy fewer amounts of goods for same money in inflation; while they can buy more amount of goods during deflation.

In comparison to inflation, deflation is considered to be problematic for the economy. This is because falling prices result in lowering of the national income, unemployment, less efficient capital, reduction in production etc.

How the Central Banks respond to deflation?

During recession and deflationary periods, the central bank of a country adopts policies like zero interest rates and quantitative easing to pull the economies out of recession. These policies are adopted with a goal of stimulating the economy and increasing the money supply.

However, the policies have failed miserably to pull the developed economies out of recession. Why? Because during deflationary trends, the people and businesses tend to avoid spending and investing and they become actively involved in hoarding of money. These activities further push the economy in to recession as the industrial production slows down due to less demand for the goods and services. Hence, the overall result is economic stagnation and unemployment. In these cases, adopting zero interest rates or buying the government securities (quantitative easing) also does not help because people would be happy to park their money even at zero interest rate. For them keeping their money safe in the bank becomes more important than investing.

Is NIRP a common monetary policy tool for central banks?

No. NIRP is not a common policy tool for central banks. Instead, it is announced when all other monetary measures have failed to simulate the economy during deflation.

How to NIRP aims to solve problem of money hoarding?

In order to solve this problem, somehow the policy adopted by the central bank should make people spend and invest their money. Here, comes into the picture an unconventional monetary policy tool named Negative interest Rate Policy (NIRP). Under the Negative Interest rate policy, nominal target interest rates have a negative value. Instead of earning interest on deposits, people will be made to pay regularly to keep their money in banks. This arrangement will make people to invest, lend and spend money instead of paying a fee to keep their investments safe in the bank.

While policies like zero interest rates and Quantitative easing failed to pull the developed economies out of recession, can NIRP prove to be otherwise?

NIRP has been implemented by the central banks of Europe, Scandinavia and Japan from 2015 on excess bank reserves in the financial system. This has proved effective than other expansionary monetary policies in spurring economic growth as the people and businesses would be incentivized to spend cash rather than hoarding it to incur a loss. Hence, NIRP proves to be a better promising alternative during recession. Having said that, it has been implemented only on excess bank reserves in the financial systems, its performance on other areas of economy is yet to be seen.

How RBI’s latest financial stability report 2016 views NIRP policy?

As per RBI’s latest Financial Stability Report, the NIRP policy aimed to encourage borrowing and risk taking; has not given encouraging result so far. Banks find it uncomfortable to pass on negative interest rates to their customers.

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