What Are Negative Interest Rates?

Negative interest rates occur when borrowers are credited interest rather than paying interest to lenders. This unusual scenario 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

  • 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.

How Does a Negative Interest Rate Work?

While real interest rates can be effectively negative if inflation exceeds the nominal interest rate, the nominal interest rate had been 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, and logic dictates that zero would be that level. 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 is -0.75%. Japan adopted a similar policy, within a mid-2020 target rate of -0.1%.

Negative interest rates may occur during deflationary periods when people and businesses hold too much money instead of spending. 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, with strong signs of deflation still a factor, simply cutting the central bank's interest rate to zero may not be sufficient enough to stimulate growth in credit and lending.

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

Understanding a Negative Interest Rate Environment

A negative interest rate environment is in effect when the nominal interest rate drops below zero percent for a specific economic zone, meaning banks and other financial firms would have to pay to keep their excess reserves stored at the central bank rather than receive positive interest income.

A negative interest rate policy (NIRP) is an unusual monetary policy tool in which nominal target interest rates are set with a negative value, below the theoretical lower bound of zero percent. During deflationary periods, people and businesses hoard money instead of spending 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.

Real World 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 as 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 worked in these countries in the way it was intended, and whether negative rates successfully spread beyond excess cash reserves in the banking system to other parts of the economy.