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Sept 11 (Reuters) - U.S. President Donald Trump hassuggested that the U.S. Federal Reserve drive interest ratesinto negative territory. He says his motivation was to refinancethe U.S. government's $22 trillion in outstanding debt andlengthen the amount of time over which it is repaid.
Negative rate policy is something Fed officials havedownplayed as appropriate in the U.S. because of the risks itentails and the likely political opposition.
Once considered only for economies with chronically lowinflation such as Europe and Japan, however, the idea isbecoming a more attractive option for some other central banksto counter unwelcome rises in their currencies.
This is how a negative rate policy works and its potentialpitfalls:
WHY HAVE SOME CENTRAL BANKS ADOPTED NEGATIVE RATES?
To battle the global financial crisis triggered by thecollapse of Lehman Brothers in 2008, many central banks cutinterest rates near zero. A decade later, interest rates remainlow in most countries due to subdued economic growth.
With little room to cut rates further, some major centralbanks have resorted to unconventional policy measures, includinga negative rate policy. The euro area, Switzerland, Denmark,Sweden and Japan have allowed rates to fall slightly below zero.
HOW DOES IT WORK?
Under a negative rate policy, financial institutions arerequired to pay interest for parking excess reserves with thecentral bank. That way, central banks penalise financialinstitutions for holding on to cash in hope of prompting them toboost lending.
The European Central Bank (ECB) introduced negative rates inJune 2014, lowering its deposit rate to -0.1% to stimulate theeconomy. Given rising economic risks, markets expect the ECB tocut the deposit rate, now at -0.4%, in September.
The Bank of Japan (BOJ) adopted negative rates in January2016, mostly to fend off an unwelcome yen spike from hurting anexport-reliant economy. It charges 0.1% interest on a portion ofexcess reserves financial institutions park with the BOJ.
WHAT ARE THE PROS, CONS?
Aside from lowering borrowing costs, advocates of negativerates say they help weaken a country's currency rate by makingit a less attractive investment than that of other currencies. Aweaker currency gives a country's export a competitive advantageand boosts inflation by pushing up import costs.
But negative rates put downward pressure on the entire yieldcurve and narrow the margin that financial institutions earnfrom lending. If prolonged ultra-low rates hurt the health offinancial institutions too much, they could hold off on lendingand damage the economy.
There are also limits to how deep central banks can pushrates into negative territory - depositors can avoid beingcharged negative rates on their bank deposits by choosing tohold physical cash instead.
WHAT ARE CENTRAL BANKS DOING TO MITIGATE THE SIDE-EFFECTS?
The BOJ adopts a tiered system under which it charges 0.1%interest only to a small portion of excess reserves financialinstitutions deposit with the central bank. It applies a zero or+0.1% interest rate to the rest of the reserves.
The ECB is also expected to take "mitigating measures," suchas a partial exemption from the charge in the form of tiereddeposits rates, if it were to deepen negative rates from thecurrent -0.4%, analysts say.
But designing such a scheme won't be easy in a bloc wherecash is distributed unevenly among countries. It could evenbackfire by pushing rates up in certain countries, rather thandown.(Reporting by Leika Kihara in Tokyo and Balazs Koranyi inFrankfurt; Editing by Alex Richardson and Nick Zieminski)