Pros and cons of NIRP
In the previous part of this series, we talked about how global economies are adopting a negative interest rate policy (or NIRP) to counter deflationary pressures and stimulate economic activity. In this part, we’ll see why economists would consider NIRP and how it could help revive a slowing economy.
NIRP is considered the most dangerous monetary instrument. It’s used to discourage commercial banks from storing money with central banks. This means banks have an incentive to borrow as much credit as they want. This also means that banks have more idle money to lend to individuals and businesses, which leads to more investment in the economy. It also leads to increased spending and thereby boosts economic growth.
However, this holds true only in theory. NIRP also helps devalue the currency, making exports more lucrative and imports expensive. This in turns helps fight deflationary pressures. Theoretically, negative interest rates also make bonds unattractive and thus make equities relatively more appealing.
However, in practice, it may actually hurt the economy. This is because borrowers are unsure about investing in a weak economy. Negative interest rates also hurt the profitability of banks. Weak banks pull back on lending, thereby weakening the economy further and thus making policymakers cut interest rates further. This creates a vicious cycle and leads to a severe financial meltdown.
Impact on the financial sector
Interest rates are a key economic variable driving the financial sector (XLF). Banks, insurance companies, and the real estate sector are closely driven by changes in the interest rate policy. The four largest consumer banks on Wall Street—JP Morgan (JPM), Wells Fargo (WFC), Bank of America (BAC), and Citigroup(C)—stand to lose billions of dollars in revenue if a negative interest rate policy comes into effect.
In the next part of this series, we’ll see how these banks are affected by NIRP.