Negative Interest Rate: Taking Deflation Head-on, But Will It Work?

I am walking down nostalgia lane, in the days when there was no Internet, no e-mail, no mobile phones. Life was simple and uncomplicated, and you were unreachable once you left office, not because you had switched off your mobile, but simply because you were actually unreachable. You read newspapers and your fingers got black and inky. You read books with the feel of paper and fell asleep with the book falling upon your face.

All businesses were structured and executed in an easy manner at that time and banking had a 2-4-6 rule. The bank borrowed at 2%, lent at 4% and bankers played golf at 6 pm. But everything has come a long way, mostly in a positive manner and sometimes in a negative way. Complicated structuring, global impacts, cyber crimes, ‘wrong’ money and commercial and financial terrorism have penetrated the system.

Banking products have also become complicated or if you want to be charitable, innovation has penetrated the system as never before.

This week, I want to write about an interesting news item I have come across.

In an unusual move, the European Central Bank (ECB) cut deposit rates below zero to minus 0.10%. ECB is the world’s first big central bank to use a negative rate. The ECB’s negative interest rate will be applicable for 18 countries that use the euro currency. Prior to this, Denmark and Sweden have also used negative deposit rates.

But what does this mean?

Well, normally, commercial banks deposit surplus money with the central bank and they get paid some interest. The actual rate depends on the monetary policies prevailing at that time. For example, if the central bank wants to control inflation, it will increase the rate it pays. On the other hand, if the central bank wants to encourage growth and spending, it will drop the rates it pays to commercial banks, thus encouraging them to lend more to consumers and fuel consumption.

But now we have a unique situation where a large central bank is discouraging ‘parking’ of funds with it by the commercial banks, by charging interest to banks that park surpluses, as against paying them interest.

Essentially, this is a move to encourage spending and revive the economy – to fight deflation. Banks, in turn, will lower deposit rates to reduce cash surpluses and also lower lending rates to encourage borrowing. This action by the ECB is a signal, an acknowledgement of a battle against deflation and the need to revive the economy.

Imagine a scenario like that in India – of course not likely to happen in the foreseeable future – but live the dream.

About the author: Satish Mehta is the Founder and Director of Credexpert, a credit and debt counselling company in India.