What Are Negative Interest Rates?

Negative interest rates occur when borrowers are credited interest rather than paying interest to lenders. While this is a very unusual scenario, it is most likely to occur during a deep economic recession when monetary policy and market forces have already pushed interest rates to their nominal zero bound.

Key Takeaways

  • Negative interest rates occur when borrowers are credited interest rather than paying interest to lenders.
  • With negative interest rates, banks charge you interest to keep cash with them, rather than paying you interest.
  • Negative interest rates might be seen during deflationary periods, when people or institutions are inclined to hoard money, rather than spend or lend it.
  • The negative interest rate is meant to be an incentive for banks to make loans during a period in which they would rather hang on to funds.
  • With negative interest rates, commercial banks are charged interest to keep cash with a nation's central bank, rather than receiving interest. Theoretically, this dynamic should trickle down to consumers and businesses, but commercial banks have been reluctant to pass negative rates onto their customers.

Understanding a Negative Interest Rate

While real interest rates can be effectively negative if inflation exceeds the nominal interest rate, the nominal interest rate is, theoretically, bounded by zero. Negative interest rates are often the result of a desperate and critical effort to boost economic growth through financial means.

The zero-bound refers to the lowest level that interest rates can fall to; some forms of logic would dictate that zero would be that lowest level. However, there are instances where negative rates have been implemented during normal times. Switzerland is one such example; as of mid-2020, their target interest rate was -0.75%. Japan adopted a similar policy, with a mid-2020 target rate of -0.1%.

Negative interest rates may occur during deflationary periods. During these times, people and businesses hold too much money (instead of spending money). This can result in a sharp decline in demand, and send prices even lower. Often, a loose monetary policy is used to deal with this type of situation. However, when there are strong signs of deflation factoring into the equation, simply cutting the central bank's interest rate to zero may not be sufficient enough to stimulate growth in both credit and lending.

In a negative interest rate environment, an entire economic zone is impacted because the nominal interest rate dips below zero; banks and other firms have to pay to store their funds at the central bank, rather than earn interest income.

A negative interest rate environment occurs when the nominal interest rate drops below zero percent for a specific economic zone. This effectively means that banks and other financial firms have to pay to keep their excess reserves stored at the central bank, rather than receiving positive interest income.

A negative interest rate policy (NIRP) is an unusual monetary policy tool. Nominal target interest rates are set with a negative value, which is below the theoretical lower bound of zero percent.

During deflationary periods, people and businesses tend to hoard money, instead of spending money and investing. The result is a collapse in aggregate demand, which leads to prices falling even further, a slowdown or halt in real production and output, and an increase in unemployment.

A loose or expansionary monetary policy is usually employed to deal with such economic stagnation. However, if deflationary forces are strong enough, simply cutting the central bank's interest rate to zero may not be sufficient to stimulate borrowing and lending.

Example of a Negative Interest Rate

In recent years, central banks in Europe, Scandinavia, and Japan have implemented a negative interest rate policy (NIRP) on excess bank reserves in the financial system. This unorthodox monetary policy tool is designed to spur economic growth through spending and investment; depositors would be incentivized to spend cash rather than store it at the bank and incur a guaranteed loss.

It's still not clear if this policy has been effective in achieving this goal in those countries, and in the way it was intended. It's also unclear whether or not negative rates have successfully spread beyond excess cash reserves in the banking system to other parts of the economy.