Negative interest rates

What Are Negative Interest Rates?

Negative interest rates occur when a central bank or financial institution charges depositors to hold their money, rather than paying them interest. In essence, the nominal interest rate falls below zero. This unconventional tool within the broader category of monetary policy is typically employed by central banks during periods of extremely low inflation or deflation and sluggish economic growth. The aim of negative interest rates is to discourage saving and encourage commercial banks to lend money, thereby stimulating spending and investment in the economy.

History and Origin

The concept of negative interest rates gained prominence as central banks sought new tools to combat economic stagnation after traditional monetary policy measures, such as lowering interest rates to near zero, had been exhausted. Denmark was among the first countries to implement negative rates on commercial bank deposits in 2012. The European Central Bank (ECB) followed suit in June 2014, becoming the first major central bank to lower one of its key interest rates into negative territory.²⁵, ²⁶ This move was part of an effort to stimulate the euro area economy and steer inflation towards its target.²⁴

The Bank of Japan (BOJ) introduced its own negative interest rate policy (NIRP) in January 2016, aiming to combat persistent deflation and spur economic activity by making it less attractive for banks to hold excess cash reserves.²¹, ²², ²³ This unconventional step marked a significant shift in Japan's monetary policy, designed to encourage lending and investment by effectively charging banks for holding reserves at the central bank.¹⁹, ²⁰

Key Takeaways

• Negative interest rates involve central banks charging commercial banks for holding excess reserves, aiming to stimulate lending and economic activity.
• They are an unconventional monetary policy tool typically used to combat deflation and spur economic growth when traditional rate cuts are no longer effective.
• The policy seeks to lower overall borrowing costs, including those for loans and government bonds, to encourage spending and investment.
• Negative interest rates can put pressure on bank profitability and may lead to charges being passed on to certain large depositors.
• While implemented in several economies, their long-term effectiveness and potential side effects remain subjects of ongoing debate among economists.

Interpreting Negative Interest Rates

When a central bank implements negative interest rates, it is signaling a strong intent to ease financial conditions and stimulate aggregate demand. The interpretation of negative interest rates is that money held as reserves at the central bank will erode in value over time, providing a direct incentive for commercial banks to lend those funds out. This is intended to translate into lower lending rates for businesses and consumers, encouraging borrowing and investment.

The goal is to push down the entire yield curve, reducing the cost of capital throughout the economy. However, the transmission of these negative rates to retail deposit rates for ordinary savers has often been limited, with banks reluctant to pass on the charges directly to avoid a mass withdrawal of funds. The policy aims to make holding cash less attractive, promoting its circulation in the economy.

Hypothetical Example

Consider a hypothetical scenario where a country's central bank implements a negative interest rate of -0.10% on excess reserves held by commercial banks.

1. Initial Situation: Commercial Bank A holds $100 million in excess reserves at the central bank.
2. Policy Implementation: The central bank introduces a negative interest rate of -0.10% on these reserves.
3. Cost of Holding Reserves: At the end of the year, instead of earning interest, Commercial Bank A would theoretically pay the central bank $100,000 ($100,000,000 * 0.0010).
4. Incentive to Lend: Faced with this cost, Commercial Bank A is incentivized to reduce its excess reserves by lending money to businesses and individuals, rather than holding it at the central bank. For instance, it might offer more attractive loan terms for mortgages or business expansion, thereby boosting credit availability and stimulating economic activity. This shift aims to inject more liquidity into the financial system.

This mechanism is designed to push banks to deploy their capital, fostering investment and consumption rather than passively holding funds with the central bank.

Practical Applications

Negative interest rates are primarily applied as an unconventional tool within the realm of central banking to influence the broader economy. Their practical applications include:

• Stimulating Lending: Central banks charge commercial banks for holding excess reserves, prompting them to lend more to businesses and consumers, rather than storing money at the central bank.¹⁷, ¹⁸ This encourages banks to increase their loan portfolios and reduce their reserve holdings.
• Lowering Borrowing Costs: The downward pressure from negative policy rates can translate into lower yields on government bonds and other financial assets, reducing overall borrowing costs across the economy. This makes it cheaper for governments and corporations to issue debt and finance projects.¹⁶
• Combating Deflation: In economies facing persistent deflationary pressures, negative interest rates aim to encourage spending and investment, which can help to increase overall demand and push prices upwards towards a central bank's inflation target.¹⁴, ¹⁵
• Currency Weakening (Potentially): By making a country's assets less attractive due to negative returns, negative interest rates can potentially lead to a weakening of the domestic currency, making exports more competitive.¹³
• Monetary Policy Accommodation: Negative interest rates provide additional space for monetary policy accommodation when the traditional zero lower bound has been reached, effectively extending the central bank's toolkit during economic downturns. An International Monetary Fund (IMF) paper from 2021 noted that negative interest rate policies "eased financial conditions" and "has likely supported growth and inflation."¹²

Limitations and Criticisms

While intended to stimulate economic activity, negative interest rates face several limitations and criticisms:

• Impact on Bank Profitability: Negative interest rates can compress banks' net interest margin (the difference between interest earned on assets and interest paid on liabilities). This is because banks are often reluctant or unable to pass on negative rates to retail depositors due to the risk of mass withdrawals or a flight to cash.¹⁰, ¹¹ Reduced profitability could, in the long run, impair banks' ability to lend, counteracting the policy's primary objective.⁸, ⁹
• "Reversal Rate" Concerns: Some economists argue there might be a "reversal rate" below which negative interest rates become counterproductive, actively hurting bank profitability and thus reducing, rather than increasing, lending.⁷
• Flight to Cash: A significant concern is that prolonged negative interest rates could encourage individuals and businesses to withdraw physical cash from banks, rendering the policy ineffective by reducing the amount of money circulating within the banking system. However, this "flight to cash" has not materialized on a massive scale in countries that implemented NIRP.⁶
• Distorted Investment Decisions: A working paper from the Federal Reserve Board suggests that in the long run, negative interest rates can distort investment decisions, lower welfare, depress output, and reduce bank profitability, particularly depending on how NIRP transmits to retail deposits.⁵
• Pension Funds and Insurers: These institutions, which rely on stable investment returns to meet long-term liabilities, can face significant challenges in a negative rate environment, potentially forcing them into riskier assets or requiring adjustments to their business models.⁴
• Limited Effectiveness: Despite their implementation, some critiques suggest that negative interest rates have had limited success in significantly boosting inflation or economic growth in certain economies that adopted them, such as Japan.

Negative Interest Rates vs. Quantitative Easing

While both negative interest rates and quantitative easing (QE) are unconventional monetary policy tools used by central banks to stimulate an economy when traditional methods are insufficient, they operate through different mechanisms.

Negative interest rates involve setting the policy rate, specifically the rate at which commercial banks deposit excess reserves with the central bank, below zero. The direct aim is to impose a cost on banks for holding idle cash, thereby incentivizing them to lend those funds to businesses and consumers. This encourages borrowing and spending by making it costly to save.

Quantitative easing (QE), on the other hand, involves a central bank purchasing large quantities of government bonds or other financial assets from the open market. The primary goals of QE are to inject liquidity into the financial system, lower long-term interest rates, and increase the money supply. By buying assets, the central bank increases demand for those assets, driving up their prices and pushing down their yields. This encourages investment and lending by making credit cheaper and more accessible.

The key distinction lies in their direct impact: negative interest rates directly penalize holding cash reserves, while QE directly increases the money supply and lowers long-term yields through asset purchases. Both aim to promote economic activity, but their operational approaches differ significantly.

FAQs

Why would a central bank implement negative interest rates?

A central bank might implement negative interest rates to combat persistent low inflation or deflation and to stimulate a sluggish economy. By charging commercial banks to hold excess reserves, the central bank aims to encourage those banks to lend more money to businesses and consumers, thereby increasing spending, investment, and ultimately, economic activity.

How do negative interest rates affect ordinary savers?

The direct impact on ordinary savers can vary. While central banks apply negative rates to commercial banks, commercial banks have often been reluctant to pass these costs directly onto individual retail depositors to avoid mass withdrawals. However, savers might experience lower or zero returns on their savings accounts or fixed-income investments as overall interest rates in the economy are pushed down.

Do negative interest rates mean I have to pay my bank to keep my money?

For most individual retail depositors, it has been rare to directly pay a bank to hold their savings, although some banks have implemented fees on very large corporate or institutional deposits. Banks typically absorb some of the costs or find other ways to offset them, rather than charging small depositors, due to competitive pressures and the risk of customers withdrawing cash.

Are negative interest rates common?

No, negative interest rates are not common and are considered an unconventional monetary policy tool. They have primarily been used by a few central banks in developed economies, such as the European Central Bank, the Bank of Japan, and those in Switzerland, Sweden, and Denmark, mainly in response to prolonged periods of low inflation and slow economic growth. As of early 2024, many of these central banks have ended their negative interest rate policies.³

What are the risks associated with negative interest rates?

Risks include potential negative impacts on bank profitability, which could reduce their capacity to lend in the long run. There are also concerns about distortions in financial markets, challenges for pension funds and insurance companies that rely on investment returns, and the possibility of encouraging a "flight to cash," although this last point has not materialized significantly where NIRP has been implemented.¹, ²