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If you’ve been a good student in our School of Pipsology, you’d know that a country’s interest rate is one of the biggest factors that determine the value of its currency. This is why traders usually keep tabs on central banks’ monetary policy biases, as well as economic data that could influence interest rate expectations.

More often than not, when there’s an interest rate hike or when traders are expecting one, demand for that country’s currency rises and so does its value. On the other hand, when a central bank cuts rates or is expected to do so, demand for their currency drops along with its value. This is because the central bank’s benchmark interest rate dictates the rate of return for holding that country’s assets.

Just this week, ECB officials caused quite a ruckus in the markets by saying that they are considering negative deposit rates. This isn’t the first time that this issue has been brought up, as ECB Governor Draghi talked about negative rates back in June. How in the world is that supposed to work?!

Positive deposit rates mean that local banks get a small return for storing some of their cash reserves with the central bank. By implementing negative deposit rates, a central bank would end up charging banks for keeping cash stored in their vaults. In other words, having negative deposit rates would discourage local banks from keeping more cash lying around instead of lending it out.

Of course changes in deposit rates also tend to have an impact on overall interest rates. You see, when banks can no longer earn returns from keeping cash with the central bank, they are likely to seek gains elsewhere. And with more cash to lend to individuals and businesses, banks won’t mind charging lower loan rates just to encourage more borrowing.

With banks getting smaller profits from lending money out, they could wind up offering lower returns on their investment products and securities. In effect, this would drag down average interest rates in the country, eventually resulting to weaker demand for its assets and currency.

The potential impact isn’t always as straightforward though, as some naysayers argue that local banks could simply pass the cost of negative deposit rates to consumers. If that’s the case, banks would end up charging higher loan rates and therefore discourage borrowing activity. This is probably one of the potential repercussions that FOMC official James Bullard is worried about when he mentioned that the Fed should study the impact of negative deposit rates.

How about you? Do you think that negative deposit rates will be an effective monetary policy move? Share your thoughts in the comment box below!