How Negative Interest Rates May Help the Canadian Economy

Last Updated on January 24, 2019

In December 2015, Bank of Canada governor Stephen Poloz gave a talk at the Empire Club of Canada in which he discussed four unconventional monetary policies which would help stimulate the Canadian economy.

The most striking of these policies was to lower the central bank interest rate below zero. The idea behind negative interest rates is being increasingly discussed around the world, although it is yet to become prominent in mainstream media. In Canada, growth forecasts for 2016 continue to be revised downward, despite the Bank of Canada’s optimistic prediction.

Negative interest rates are a relatively new economic policy tools. Central banks in countries such as Switzerland, Japan and Denmark have already implemented them.

Negative interest rates are unfortunately a continued sign of Canada’s inability to stimulate domestic economies in the absence of fiscal policy.

To better understand the importance of negative rates, two important issues must be considered. First, monetary policy has in a way exhausted its ability to stimulate the economy because of what economists call the “zero lower bound.”

In normal times, interest rates cannot be forced below zero. However, these are not normal times: the Canadian economy is going through its worst performance since the Great Depression. After having fallen back into recession in the first part of 2015, prospects for 2016 and 2017 are bleak with another possible recession in the near horizon.

At such low rates monetary policy becomes largely ineffective because the central bank is running out of room to lower rates. This brings us to the second point: central banks, and especially the Bank of Canada, believe that a negative rate of interest would bring the economy back to full employment. Economists call this the natural rate.

Some say the Bank of Canada will set its rate at minus one per cent in 2016.

Mr. Poloz has said “the effective lower bound for Canada’s policy rate is around minus 0.5 per cent, but it could be a little higher or lower.”

How do negative rates work? The Bank of Canada offers interest on the deposits of the commercial banks at the central bank, just like commercial banks offer us interest on our deposits with them. With negative rates, commercial banks would now have to pay the central bank to hold deposits with them. By charging interest on bank deposits, the central bank hopes banks will want to avoid paying interest and instead start lending out their excess funds again, therefore helping the economy get back to full employment.

However negative interest rates may not capture the reality that banks do not lend because they are unwilling to lend in such uncertain economic times. Banks lend in the hope of getting reimbursed with interest. But if banks are pessimistic about the ability of the private sector to honour debt loads, there will be a continuing reluctance to incur lending risk.

Negative interest rates may likewise not help consumers because as the record reflects in the last two rate decreases, banks have been unwilling to pass through the full effect of rate decreases.  It is plausible that by lowering rates to zero or below, banks will pass only a small portion of this saving to borrowers.

What the Canadian economy needs is a combination of a measured rate decrease combined with sizeable fiscal stimulus from Ottawa.

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