Negative interest rates are a term you’ve probably heard but may not totally understand. In this article, we’ll cover what negative interest rates are, why they might be used, and how they might affect consumers.
In this guide, we review the aspects of What Is Negative Interest Rate, how do negative interest rates work, negative interest rates on savings, and what happens when real interest rate is negative.
What Is Negative Interest Rate
Negative interest rates are a relatively new phenomenon. In fact, before the financial crisis of 2008, no country had ever adopted negative interest rates as part of its monetary policy (though Iceland came close in 2009).
Since then, however, several central banks have introduced negative interest rates into their economy to stimulate spending and investment as an alternative to quantitative easing.
How exactly does this work? The theory behind it is pretty simple: people don’t like losing money; therefore they’ll do whatever they can to avoid doing so. If you offer them a way out—a safe place where they can invest their hard-earned cash without getting paid any interest—they’ll take it.
For example, let’s say you’re the government of Germany or Japan and you want people who normally put their money into savings accounts with positive interest rates (such as CDs) to start putting that money into government bonds instead—that way it helps stabilize your economy during times of economic turmoil (like now). Offering an incentive could be enough for some people who otherwise wouldn’t think about trying something different like investing in bonds because they don’t want their money sitting idly by while earning zero percent interest on it!
Negative interest rate policies may also encourage more commercial real estate construction by lowering borrowing costs for developers who need capital for major projects such as hotels or shopping centers.”
Why It Might Be Used
There are a few reasons why negative interest rate might be used as a monetary policy tool.
First, it’s all about stimulating the economy. When people have more money in their pockets, they’re more likely to spend it on things that help boost the economy and create jobs. They can spend on new cars or homes, or just put some extra cash in their savings account for retirement or a rainy day fund. This helps stimulate businesses that depend on people buying goods and services from them like restaurants (which will give you more money by eating out) or grocery stores (which sell food).
Negative interest rates help encourage people to save money as well: if you’re earning less than 0% interest on your bank account but still owe something on your credit card bill (and most of us do), then putting some extra cash into savings makes sense!
When It May Be Used Again
When the economy is in a recession, interest rates are already at zero and the economy is in a deflationary spiral or inflation is too low.
Potential Impact on Consumers
The impact on consumers is the same as it was in the past.
Negative interest rates may mean that you’ll have less money in your account than before, but the impact on consumers isn’t all bad. One upside is that people with savings accounts will have more money. After all, banks don’t pay for deposits anymore! But if you tend to save more than spend and are looking for ways to build your savings further, this can be a good thing: You’ll earn more interest than ever before. That said, it’s hard to predict how much negative interest rates will affect consumers’ behavior because they’re so new (and some countries haven’t even tried them yet). It’s likely that we’ll see some negative impacts—especially if these types of policies become widespread and last for long periods of time—but overall we expect it’ll be good news for those who maintain their savings accounts at banks or credit unions rather than using cash or cryptocurrencies like Bitcoin instead
If you’re new to this topic, the takeaway is that a negative interest rate is when a bank charges you for depositing money in your account. It may sound weird, but it’s actually been tried several times before—and there are some good reasons why it could make sense in the future.
It is important to understand how negative interest rates work and how they can affect you. However, negative interest rates are still a fairly new phenomenon that we have yet to see used in practice. As such, it is too early to tell what their impact will be on consumers or businesses alike.
how do negative interest rates work
Interest rates are often defined as the price paid to borrow money. For example, an annualized 2% interest rate on a $100 loan means that the borrower must repay the initial loan amount plus an additional $2 after one full year. So what does it mean when we have a negative interest rate—meaning borrowers are credited interest, instead of being charged it? That, say, a -2% interest rate means the bank pays the borrower $2 after a year of using the $100 loan?
At first glance, negative interest rates seem like a counterintuitive, if not downright crazy, strategy. Why would a lender be willing to pay someone to borrow money, considering the lender is the one taking the risk of loan default? Inside-out as it might appear, though, there are times when central banks run out of policy options to stimulate their nations’ economies and turn to the desperate measure of negative interest rates.
Negative Interest Rates in Theory and Practice
Negative interest rates are not only an unconventional monetary policy tool, but they are also a recent one. Sweden’s central bank was the first to deploy them: In July 2009, the Riksbank cut its overnight deposit rate to -0.25%. The European Central Bank (ECB) followed suit in June 2014 when it lowered its deposit rate to -0.1%. Other European countries and Japan have since opted to offer negative interest rates, resulting in $9.5 trillion worth of government debt carrying negative yields in 2017.
Why did they take this drastic measure? The monetary policymakers were afraid that Europe was at risk of falling into a deflationary spiral. In harsh economic times, people and businesses tend to hold on to their cash while they wait for the economy to improve. But this behavior can weaken the economy further, as a lack of spending causes further job losses, lowers profits, and prices to drop—all of which reinforces people’s fears, giving them even more incentive to hoard. As spending slows even more, prices drop again, creating another incentive for people to wait as prices fall further. And so on.
This is precisely the deflationary spiral that European central banks are trying to avoid with the negative-interest strategy, which not only affects bank loans but bank deposits.
When you deposit money in an account at a financial institution, you are in effect becoming a lender—letting the bank have use of your funds—and the institution effectively becomes a borrower.
With negative interest rates, cash deposited at a bank yields a storage charge, rather than the opportunity to earn interest income. By charging European banks to store their reserves at the central bank, the policyholders hope to encourage banks to lend more.
In theory, banks would rather lend money to borrowers and earn at least some interest as opposed to being charged to hold their money at a central bank. Additionally, negative rates charged by a central bank may carry over to deposit accounts and loans. This means that deposit holders would also be charged for parking their money at their local bank while some borrowers enjoy the privilege of actually earning money by taking out a loan.
Another primary reason the ECB has turned to negative interest rates is to lower the value of the euro. Low or negative yields on European debt will deter foreign investors, thus weakening demand for the euro. While this decreases the supply of financial capital, Europe’s problem is not one of supply but of demand. A weaker euro should stimulate demand for exports and, hopefully, encourage businesses to expand.
Risks of Negative Interest Rates
In theory, negative interest rates should help to stimulate economic activity and stave off inflation, but policymakers remain cautious because there are several ways such a policy could backfire. Because banks have certain assets such as mortgages that are contractually tied to the prevailing interest rate, such negative rates could squeeze profit margins to the point where banks are actually willing to lend less.
There is also nothing to stop deposit holders from withdrawing their money and stuffing the physical cash in mattresses. While the initial threat would be a run on banks, the drain of cash from the banking system could lead to a rise in interest rates—the exact opposite of what negative interest rates are supposed to achieve.
Although the Federal Reserve, the U.S. central bank, has never imposed negative interest rates, it has come close with near-zero rates—most recently on Mar. 15, 2020, when it cut the benchmark interest rate to a 0%–0.25% range.
negative interest rates on savings
The U.S. economy is slipping into what could be a severe recession, and the Federal Reserve is taking unprecedented measures to help it survive the consequences of the COVID-19 pandemic.
The Fed stepped in with an emergency rate cut in March. It has injected $2.3 trillion into the economy through emergency initiatives such as buying municipal bonds and lending money to small and mid-size businesses that don’t qualify for Small Business Administration emergency loans. It’s even buying corporate bond ETFs.
These measures show the Fed is doing whatever it takes to prop up the economy. Until now, it had never utilized its authority to purchase municipal bonds or ETFs. But there has been heated debate over a controversial monetary policy tool that’s also at the Fed’s disposal: Negative interest rates.
They’ve been used by other global central banks, to mixed results. Are negative interest rates really in the cards for the U.S.? If so, what might they mean for your wallet? Here’s what you should know.
What Are Negative Interest Rates?
Interest rates are one of the main levers the Federal Reserve uses to adjust monetary policy and maintain balance in the U.S. economy. The central bank adjusts the federal funds rate to guide how individual banks and lenders determine their own rates.
The Fed raises interest rates to help cushion the economy against inflation, because higher rates make borrowing by consumers and businesses more expensive. It lowers interest rates when the country is facing a recession because it encourages borrowing and spending, which stimulate the economy.
So what about negative interest rates? If a central bank implements negative rates, that means interest rates fall below 0%. In theory, negative rates would boost the economy by encouraging consumers and banks to take more risk through borrowing and lending money.
Negative Interest Rates Fight Deflation
In economic downturns, people typically hold onto their money and wait to see some sort of improvement before they ramp up spending again. As a result, deflation can become entrenched in the economy: People stop spending, demand declines, prices for goods and services fall, and people wait for even lower prices before spending. It’s a pernicious cycle that can be very hard to break.
Negative rates fight deflation by making it more costly to hold onto money, incentivising spending. Theoretically, negative interest rates would make it less appealing to keep cash in the bank; instead of earning interest on savings, depositors could be charged a holding fee by the bank. Simultaneously, negative interest rates would make it more appealing to borrow money, since it would push loan rates to rock-bottom lows.
Negative Interest Rates In Japan and Europe
In 2014, the European Central Bank (ECB) was the first central bank to adopt a negative interest rate policy, to address the eurozone crisis. The ECB lowered its deposit rate to -0.1% that year in an attempt to hold off deflation and move the economic bloc out of a protracted malaise. Today, the current ECB deposit rate is -0.5%, the lowest on record.
The Bank of Japan (BoJ) has been fighting deflation for two decades. It was the first central bank to move to a zero interest policy in 1999, and its key rate has been negative since 2016. Neither the BoJ nor the ECB have been able to move rates back into positive territory.
In Europe, inflation has remained anemic and many argue that consumers have simply responded to negative rates by moving their savings around to banks offering higher yields, even if it’s by a few tenths of a percentage point, as reported by the Wall Street Journal. Some banks report that big depositors are requesting their physical cash be put in vaults where it can avoid the negative interest rates, and businesses have held back on spending and resisted the “temptation of cheap money.”
One research paper from the ECB found no evidence that negative rates were incentivizing households, corporations and non-bank financial institutions to keep more cash on hand with the intention of pumping it into the economy. Meanwhile, a research paper from the Swedish House of Finance suggests the opposite, stating that the monetary policy remains effective when it’s implemented with measures to make it more costly for hoarding cash.
Are Negative Interest Rates Coming to the U.S.?
You’ve probably heard some buzz around negative interest rates over recent weeks. President Donald Trump has expressed his interest on Twitter, calling negative interest rates a “gift” for the economy. Investors in future markets have started betting on the Fed implementing them, helping to keep the idea in the headlines.
But the Federal Reserve insists negative interest rates are not on the table.
As of now, the Fed remains adamant against implementing negative rates as a tool to help stabilize the U.S. economy, even assuming they would work as promised. Federal Reserve Chairman Jerome Powell has repeatedly said that negative rates are not something that will be implemented.
“I continue to think, and my colleagues on the Federal Open Market Committee continue to think that negative interest rates is probably not an appropriate or useful policy for us here in the United States,” said Chairman Powell in a recent 60 Minutes interview. “The evidence on whether it helps is quite mixed.”
Joe Brusuelas, chief economist at RSM, believes implementing negative interest rates wouldn’t be an easy task. Plus, he also doubts they would be the best way to help the economy now—although implementing them wouldn’t be an impossible undertaking for the Fed.
“It’s very difficult to do and it requires some pre-conditions to be set by regulatory agencies and the central bank to make it work,” Brusuelas says. “It’s highly conditional. You’re only going to do this under very specific or quite dire circumstances. This isn’t something that’s going to be turned to just because the bond market is turning to a wavy type recovery.”
what happens when real interest rate is negative
Central banks are starting to experiment with negative interest rates to stimulate their countries’ economies
Money has been around for a long time. And we have always paid for using someone else’s money or savings. The charge for doing this is known by many different words, from prayog in ancient Sanskrit to interest in modern English. The oldest known example of an institutionalized, legal interest rate is found in the Laws of Eshnunna, an ancient Babylonian text dating back to about 2000 BC.
For most of history, nominal interest rates—stated rates that borrowers pay on a loan—have been positive, that is, greater than zero. However, consider what happens when the rate of inflation exceeds the return on savings or loans. When inflation is 3 percent, and the interest rate on a loan is 2 percent, the lender’s return after inflation is less than zero. In such a situation, we say the real interest rate—the nominal rate minus the rate of inflation—is negative.
In modern times, central banks have charged a positive nominal interest rate when lending out short-term funds to regulate the business cycle. However, in recent years, an increasing number of central banks have resorted to low-rate policies. Several, including the European Central Bank and the central banks of Denmark, Japan, Sweden, and Switzerland, have started experimenting with negative interest rates —essentially making banks pay to park their excess cash at the central bank. The aim is to encourage banks to lend out those funds instead, thereby countering the weak growth that persisted after the 2008 global financial crisis. For many, the world was turned upside down: Savers would now earn a negative return, while borrowers get paid to borrow money? It is not that simple.
Simply put, interest is the cost of credit or the cost of money. It is the amount a borrower agrees to pay to compensate a lender for using her money and to account for the associated risks. Economic theories underpinning interest rates vary, some pointing to interactions between the supply of savings and the demand for investment and others to the balance between money supply and demand. According to these theories, interest rates must be positive to motivate saving, and investors demand progressively higher interest rates the longer money is borrowed to compensate for the heightened risk involved in tying up their money longer. Hence, under normal circumstances, interest rates would be positive, and the longer the term, the higher the interest rate would have to be. Moreover, to know what an investment effectively yields or what a loan costs, it important to account for inflation, the rate at which money loses value. Expectations of inflation are therefore a key driver of longer-term interest rates.
While there are many different interest rates in financial markets, the policy interest rate set by a country’s central bank provides the key benchmark for borrowing costs in the country’s economy. Central banks vary the policy rate in response to changes in the economic cycle and to steer the country’s economy by influencing many different (mainly short-term) interest rates. Higher policy rates provide incentives for saving, while lower rates motivate consumption and reduce the cost of business investment. A guidepost for central bankers in setting the policy rate is the concept of the neutral rate of interest : the long-term interest rate that is consistent with stable inflation. The neutral interest rate neither stimulates nor restrains economic growth. When interest rates are lower than the neutral rate, monetary policy is expansionary, and when they are higher, it is contractionary.
Today, there is broad agreement that, in many countries, this neutral interest rate has been on a clear downward trend for decades and is probably lower than previously assumed. But the drivers of this decline are not well understood. Some have emphasized the role of factors like long-term demographic trends (especially the aging societies in advanced economies), weak productivity growth, and the shortage of safe assets. Separately, persistently low inflation in advanced economies, often significantly below their targets or long-term averages, appears to have lowered markets’ long-term inflation expectations. The combination of these factors likely explains the striking situation in today’s bond markets: not only have long-term interest rates fallen, but in many countries, they are now negative.
Returning to monetary policy, following the global financial crisis, central banks cut nominal interest rates aggressively, in many cases to zero or close to zero. We call this the zero lower bound, a point below which some believed that interest rates could not go. But monetary policy affects an economy through similar mechanics both above and below zero. Indeed, negative interest rates also give consumers and businesses an incentive to spend or invest money rather than leave it in their bank accounts, where the value would be eroded by inflation. Overall, these aggressively low interest rates have probably helped somewhat, where implemented, in stimulating economic activity, though there remain uncertainties about side effects and risks.
A first concern with negative rates is their potential impact on bank profitability. Banks perform a key function by matching savings to useful projects that generate a high rate of return. In turn, they earn a spread, the difference between what they pay savers (depositors) and what they charge on the loans they make. When central banks lower their policy rates, the general tendency is for this spread to be reduced, as overall lending and longer-term interest rates tend to fall. When rates go below zero, banks may be reluctant to pass on the negative interest rates to their depositors by charging fees on their savings for fear that they will withdraw their deposits. If banks refrain from negative rates on deposits, this could in principle turn the lending spread negative, because the return on a loan would not cover the cost of holding deposits. This could in turn lower bank profitability and undermine financial system stability.
A second concern with negative interest rates on bank deposits is that they would give savers an incentive to switch out of deposits into holding cash. After all, it is not possible to reduce cash’s face value (though some have proposed getting rid of cash altogether to make deeply negative rates feasible when needed). Hence there has been a concern that negative rates could reach a tipping point beyond which savers would flood out of banks and park their money in cash outside the banking system. We don’t know for sure where such an effective lower bound on interest rates is. In some scenarios, going below this lower bound could undermine financial system liquidity and stability.
In practice, banks can charge other fees to recoup costs, and rates have not gotten negative enough for banks to try to pass on negative rates to small depositors (larger depositors have accepted some negative rates for the convenience of holding money in banks). But the concern remains about the limits to negative interest rate policies so long as cash exists as an alternative.
Overall, a low neutral rate implies that short-term interest rates could more frequently hit the zero lower bound and remain there for extended periods of time. As this occurs, central banks may increasingly need to resort to what were previously thought of as unconventional policies, including negative policy interest rates.