Most people are familiar with the risks of inflation, where the value of a currency plummets and goods become more expensive. Deflation (not to be confused with disinflation, a reduction in the rate of inflation) is a reduction in the level of pricing. Plummeting prices theoretically cause consumers (as a whole) to wait for lower prices.
This causes a decrease in demand, which induces an increase in supply. Businesses are less profitable and as a result, wages and employment rates decrease, further adding to the deflationary spiral.
Central banks then attempt to influence spending by making it profitable to use loans while making consumers and businesses pay to keep funds in bank accounts—by introducing negative interest rates.
Negative Interest Rates
Interest rates are a monetary policy tool used by central banks to influence inflation throughout an economy. A central bank attempts to combat deflation by reducing interest rates in order to encourage consumers and businesses to use more loans. This increases demand, which raises prices. This is one of the many conventional monetary policies.
Conventional monetary policies have not been as effective in recent times. A newer train of thought is for a country's central bank to lower interest rates past zero, into negative rates. This move is designed to incentivize banks to lend money while influencing businesses and consumers to spend, rather than pay fees in order to keep their cash in an account at a bank.
The European Central Bank introduced its negative interest rate policy in 2014; in January of 2016, the Bank of Japan unexpectedly did the same, cutting its benchmark rates below zero in a bold move to stimulate its economy and overcome persistent deflationary pressures.
The graph below illustrates Japan's 10-year government bond yields from 2012 through the present.
Impact on Economics & Markets
Economists and monetary policymakers argue about the effectiveness of this action, since carrying it out results in savers being penalized and borrowers being paid—a complete reversal of circumstances everyone is accustomed to. The impact of negative interest rates is difficult to quantify since the policy has been used sparingly in the past.
Banks may be reluctant to pass on the cost of negative interest rates to their customers because doing so may encourage them to move their assets. In these cases, negative interest rates would lower the profits of banks and discourage them from lending.
Consumers facing fees to have cash in an account may decide to take the money out of the financial system altogether at the same time (called a bank run)—witnessed on more than a few occasions throughout history.
The impact of these policies on the foreign exchange market has been much more favorable. When negative interest rates are in place, investors tend to search for better returns in foreign markets, which influences a decrease in their country's currency valuation. However, if negative interest rates continue gaining worldwide popularity, this might not remain an option.
Takeaways for Investors
Negative interest rates are designed to combat deflation by encouraging people and businesses to borrow and spend money. Since this method has been implemented only a few times in the past, in very different circumstances, their effects are difficult to quantify.
It is difficult for investors to find yields in a negative rate economy. Most investors will be looking outside of the United States for opportunities if the rates are dropped into the negative.
The one course of action investors should take (which is likely to be a large number of smaller actions) is to create a strategy to deal with the possibility of negative interest rates, to reduce the amount of risk on the occasion that negative interest rates are introduced in the U.S.