The economic uncertainty triggered by the coronavirus pandemic has led people to be more cautious with their money. Central Banks adjust interest rates to stabilize economic growth and this is how…
What are Negative Interest Rates?
A positive interest rate is the extra money you receive from your bank, where a negative interest rate means you lose money from holding it in a bank. This charge or cost for the lender is rare and for some people, they’re unheard of. But negative interest rates play a key role in stabilizing economic growth.
With the global pandemic going strong, interest rates have been dropping as decision-makers have been focusing on limited economic damage. Currently zero-percent interest rates are common, but with the virus here to stay, will central banks have to push interest rates to go negative to boost growth and prosperity and tackle rising unemployment rates? Central banks use interest rates to control inflation by adjusting the cost of money with the goal of keeping the economy running at the optimum level. If economic growth and inflation need to be checked then interest rates will be elevated, whereas if growth and inflation are below the central banks targets interest rates will be lowered to give the economy a boost. At lower interest rates, the cost of borrowing is lowered to encourage spending and inject life in the economy, while raising interest rates stagnate spending to control the rate of growth.
Examples across the World
Negative interest rates are rare but not unfamiliar to the most prosperous economies of the world, including Switzerland, Denmark and Japan. This means it costs banks to deposit money with central banks and as a result consumer banks will encourage loans at low cost to the public to counter the cost of depositing money in central banks.
Central banks worldwide are considering pushing interest rates into the negative to boost spending to counter the effects of COVID-19. However, central banks have other tools apart from interest rates in their armery which can boost the economy without costing those who want to save. For example, they can increase quantitative easing to improve liquidity.
What’s bad about negative interest rates?
Positive interest rates supports the banking sector as it supports profit from loaning to the public. Public banks are at risk when negative interest rates are employed as it lowers their turnover.
Another issue is the failure to see positive results from adjusting interest rates. The aim of slashing interest rates is to boost growth and inflation by encouraging consumer spending. However, this cannot overcome personal finance problems due to higher employment rates and uncertainty brought by coronavirus, which lends people to be more conservative with their money, no matter what strategy central banks impose. This would mean there is little economic growth despite encouragement from central banks to inject money in the economy.
There is still dispute over the effectiveness of negative interest rates as other monetary tools are implemented to boost market liquidity when inflation and growth are lacking. Introducing negative interest rates is a fallback for unsuccessful measures, hinting at the extremeness of the economic crisis. A lot of countries’ central banks will be faced with this dilemma as other monetary tools prove ineffective.
What does this mean for the stock market?
The stock market is the most rapid to react to changes in interest rates. Companies are affected by bank rates directly, so as interest rates drop they can afford to take out loans that will encourage growth. Economic growth for a company boosts stock prices. However, companies are also affected indirectly, as lower interest rates encourage spending of disposable income, revenues will be boosted, in turn, increasing stock prices.
The change in interest rates causes volatility and therefore rapid changes in stock prices. Traders can take advantage of this market change as initial changes in stock price are smoothed or rebounded over time. Furthermore, the premonition of interest rate changes is enough to cause volatility as traders project changes to the stock market ahead of central bank announcements. Traders often keep a close eye on an economic calendar which clocks announcements that influence the stock market in order to predict events and make a profit.
Although volatility creates opportunity for profit, there is also increased risk. So be careful and keep up to date with the latest economic news with BullBear.