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The European Central Bank (ECB) has been in what you might call a tough spot. In 2014, it implemented negative interest rates, pioneering one of the most controversial policies that have remained so even today.
It began at -0.1% but long before that; the ECB had hovered around the 0% mark. Seven years later, we’re now at a roughly -0.5% interest rate. Experts predict the trend will continue for a few more years.
Normally, if you earn 0.5% interest on your deposits, then now with negative interest rates, the opposite happens. Yes, we’ve scaled it down a billion times, but that is essentially the frame of a pretty bad picture.
Despite its severe economic implications, the intention behind negative interest rates isn’t bad. The goal here is to stimulate the economy but in the most forceful way. Commercial banks are reluctant to deposit their cash reserves, so they lend them to the next guy they see.
Guess whose money they’re lending out at rock bottom rates? That’s right, yours.
Domestic depositors and small business owners began seeking alternatives to counteract the policy. One strategy entailed putting their cash in the vault so no interest would incur.
The purpose of negative interest rates was to encourage people to withdraw their money and then spend it. Well, the ECB has managed to do half of that. For several years after following the new policy, domestic spending remained unenthusiastic.
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We’ll get into more detail at the end of this article, and in the meantime, let’s talk about the ECB negative interest rate policy and how it affects you as consumers.
How Negative Interest Rates Work
When you put money in the bank, it pays you an interest rate. This is the amount you earn for not spending all of it at once. The bank then uses that money to lend to other people and businesses and charges them an interest rate higher than what they pay you. The more people deposit, the more they can loan out.
Eventually, the bank would have more money than they can lend. When this happens, they would lend to other banks or store the extra cash in the central bank. This way, they will earn interest rates on those ends. The central bank, however, oversees the interest rate. It gets to decide how much commercial banks should charge.
When the interest rate is negative, not only will the bank won’t earn any money, it has to pay the central bank for having extra cash. There is a standard on how much money banks are allowed to have in their reserves. Anything above that will be penalized. The more a bank has in its reserves, the more interest it needs to pay.
How Negative Interest Rates Affect You
The whole purpose of a negative interest rate policy is to incentivize spending. So, what’s a better way than to force the bank to give money to people?
When it’s costly to hold on to money, banks will find ways to pour it out to the market. They will lower lending rates, including business loans and even mortgages, to get people to borrow more. Some banks will raise service charges to their customers or impose holding fees so they would withdraw more cash.
As a consumer, you’re now earning less on your bank deposits and paying more to do so. Another problem is when lending rates are low, people tend to venture into materialistic territory that was previously unattainable, i.e., buying a house. It seems like a good thing, but the only thing that does is raise house prices for everyone else. The same thing applies to cars, mortgages, and small businesses.
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