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How Do Negative Interest Rates Work?

October 27, 2020 · 9 minute read

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How Do Negative Interest Rates Work?

When you put money in the bank, the bank pays you interest. In exchange you allow them to lend out your cash to other bank customers.

But what if that interest rate was negative? Would you have to pay the bank to hold on to your money for you? Theoretically the answer is yes. But here’s a deeper look at how negative interest rates work, and how they’ve been used around the world.

What Are Negative Interest Rates?

Negative interest rates, or interest rates below 0%, flip the traditional lender/borrower relationship on its head. Savers must pay to park their money in the bank.

And theoretically, rather than pay interest to borrow money, borrowers could actually be credited interest. Imagine a bank paying you to take out a mortgage.

An interest rate is the price banks, businesses, and individual consumers pay to borrow money. The average consumer pays interest on the loans they take out to buy a car or a house. And when they save money in a bank, the bank pays interest to them for the right to lend that money out to other customers.

The interest rates consumers pay are determined in large part by the actions taken by central banks, such as the Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan.

Among its many jobs, the Federal Reserve sets interest rates for the U.S. by setting the federal funds rate. This is the interest rate that banks must pay when they borrow money overnight to meet the Federal Reserve’s minimum reserve requirements.

The federal funds rate produces a ripple down effect that helps determine how much consumers and businesses are charged to borrow. Banks set their prime rate based on the target level of the federal funds rate.

Under a negative interest rate policy, the Federal Reserve would charge interest for financial institutions to hold their excess reserves with the central bank. In this way, banks would be penalized for hanging onto money and would be more likely to lend it out.

Banks could theoretically pass the cost of such a program on to their customers by charging them a negative rate in turn.

Negative interest rates tend to occur during deep recessions when rates are already near zero.

When Would a Country Use a Negative Interest Rate?

When a country is in a recession, its economy stops growing and actually reverses direction. These periods are often accompanied by falling stock markets, decreased income and consumer spending, and higher unemployment.

Governments have a number of tools to help pull the economy out of recession, including monetary and fiscal stimuli.
A monetary stimulus includes lowering the interest rate, while a fiscal stimulus can come in the form of tax breaks or even direct distributions of cash.

Here’s the theory:
Central banks often use their ability to lower interest rates as their first line of defense to stimulate the economy. When the economy hits a rough patch, businesses and consumers might be tempted to hang onto cash while they wait for it to get better.

As the central banks lower interest rates, the cost of borrowing is reduced for individuals and businesses, encouraging them to spend. When interest rates are lower, people are more encouraged to borrow, which circulates more cash through the economy. As spending increases, so too does demand, which drives prices up and can help combat deflation.

If the economy is still underperforming, the government and central bank has to find another way to stimulate it through measures such as quantitative easing.

Often seen as a last resort when lowering interest rates fails, quantitative easing is the process by which central banks buy up existing government bonds to inject money into the financial system.

Conventional monetary policies haven’t always been effective in stimulating the economy.

So what’s a central bank to do when these measures fail? In recent times, a new line of thinking has emerged that pushes the idea of lowering interest rates below the zero point threshold. And countries from Switzerland to Japan have given it a try.

Have Negative Interest Rates Ever Been Used?

Until relatively recently, negative interest rates were basically unheard of. After the financial crisis of 2008, they came to be seen by some central banks as an experimental policy worth pursuing after more traditional economic stimulus options weren’t effective at reviving ailing economies.

At that time in the U.S., the Federal Reserve pursued a different route, cutting the interest rate to zero and instituting a bond-buyback program to try and push down long-term interest rates.

However, in 2014, the European Central Bank (ECB) decided to give negative interest rates a try, and the Bank of Japan (BOJ) followed suit two years later.

Switzerland, Denmark, and Sweden have also experimented with allowing their interest rates to slip below zero. They bet that consumers would want to borrow money at a profit and spend money, rather than be penalized to hold it in a bank.

Central bank officials also thought that negative interest rates might put downward pressure on the price of their currency, which in turn would stimulate exports. As the prices of a nation’s currency drops, it becomes cheaper for other countries to buy goods from them.

The ECB and BOJ were also hoping to head off the threat of deflation in which falling prices threaten to increase economic distress.

What Happens When Rates Are Negative?

In theory, negative interest rates sound like a good idea in certain situations. For one, banks that are hoarding money are punished, which encourages them to lend more money.

This lending leads to increased spending and borrowing, which injects much needed cash into the economy. Negative rates could head off a deflationary spiral that could keep a country in economic hardship for longer, and it could also stimulate the export economy. However, theories don’t always play out as policymakers expect.

First, lenders want to be compensated for taking on the risk of lending money to borrowers. They also make money off of interest rates. And if they can’t make money, they may actually be deterred from lending at all, which can slow down the economy.

This has been the case in some countries in Europe, for example. As a result, demand doesn’t grow as fast as it should, the economy lags, and interest rates have to be kept lower for longer.

Something interesting starts to happen when interest rates approach zero, also known as zero-bound—theoretically the lowest point to which a central bank can cut rates. Near-zero rates can result in a “liquidity trap” as individuals, businesses, and banks hoard money rather than spending it, which keeps money from circulating in the economy.

Some policy makers have issued other warnings about negative rates. For example, they fear that if more banks use the strategy as a stimulus it could lead to currency wars as nations devalue their currencies.

In the U.S., President Donald Trump has often called for negative interest rates, and complained that the Federal Reserve has avoided them.

That’s because as the gap between rates in the U.S. and other countries grows, global investors turn their attention to dollar-denominated assets. This in turn drives up demand for the dollar and the value of the currency, which could harm U.S. exports.

Though negative rates in the countries that have them are slight, there is a possibility that lowering them too much could cause a run on the bank.

If banks charge consumers too much to hold their money, consumers may be tempted to pull their money out and spend it, stuff it under their mattress, or look for another investment that could help them outpace inflation.

To mitigate the side effects of negative interest rates, both the ECB and the BOJ have adopted a tiered system that shields a portion of their reserves.

How Does the Tiered System Function?

In an effort to encourage banks to continue lending money despite a negative interest rate, the ECB, BOJ, and Switzerland have initiated a tiered system. Banks apply a negative interest rate to only a small portion of the reserves they hold with the central bank.

They then pay little or no interest at all on the rest, which makes the charges more affordable. The scheme works because banks are willing to make loans that earn even a little bit more than the central bank’s worst rate.

In Japan, for example, the BOJ’s tiered system charges a -0.1% interest rate on a small portion of the reserves that banks deposit with it. It pays a 0% or 0.1% interest rate on the rest of the reserves.

The ECB uses a different tiering system, which went into effect in fall 2019. Reserves as much as six times the minimum amount the bank is required to hold are exempt, and the interest rate will be 0%. Anything above that will be subject to a negative interest rate of -0.5%.

Switzerland uses a two-tiered system, charging 0% on an amount up to 20 times the reserve requirement and -0.75% on the rest.

Do Negative Interest Rates Work?

Negative interest rates present potential pitfalls and to make them work, economies have had to resort to tiered systems that shield financial institutions from having to pay to keep stashing most of their cash with the central bank. These factors beg the question, do negative interest rates work? The answer is yes, but the effects may be slight.

Consider that Sweden abandoned its negative interest rate when it raised rates up to 0% in late 2019. The Riksbank, the country’s central bank, cited the potentially harmful side effects of maintaining negative rates for too long.

It feared that businesses and households would take on too much debt or that banks would be forced to charge to take deposits, which could cause a run on the banks. In 2009, the Riksbank became the first ever to charge commercial banks to hold their cash.

Shortly after The Riksbank’s announcement, the ECB published a study that staunchly defended the use of negative rates, claiming the benefits of negative rates still outweighed the potential harm raising rates would cause, even if negative rates were doubled. However, while the Riksbanks agree that negative rates have had a positive effect, it still questions what the long-term impact may be.

Even so, the ECB insists that negative interest rates along with a program that includes bond buying and long-term loans to banks provides multiple benefits. Some of the positives highlighted in the study include showing that proving there is no zero-bound demonstrates that central banks still have power to act when interest rates hit 0%. Second, the ECB says that negative rates do in fact encourage commercial banks to lend more.

Negative rates helped forward guidance from the central bank—communication about future monetary policy–as well as corporate bond purchases be more effective. And the study claims that banks have actually made more money with negative rates than they would have if rates had been positive. This odd result comes from rising fees, capital gains which help offset the cost of negative interest to the bank.

Countries that share Sweden’s concerns may avoid negative interest rates entirely, or try them out as a short-term program.

Will the U.S. Ever Go Negative?

The U.S. has never had a negative interest rate. However, there have been whispers about the Federal Reserve considering using one for years to combat major economic downturns, like the one caused by the novel coronavirus pandemic.

Federal Reserve Chairman Jerome Powell has said it’s unlikely that the Federal Reserve will cut its short-term rates to address the financial crisis. Instead the organization will focus on interest rates—it cut the federal funds rate to 0%—and quantitative easing measures, including $700 billion in asset purchasing.

Staying Up-to-Date on Interest Rates

The back and forth about negative interest rates could cause confusion to investors—and some related stress. It’s helpful to know what’s going on with the market and economy—and to get support and guidance on financial decisions.

Fortunately, SoFi offers an easy-to-use app that provides current market news. Additionally, there are financial planners available to chat about financial decisions and goals—decreasing stress and increasing knowhow.

Interested in keeping up with the latest on this and other topics? Download the SoFi App to stay up-to-date on the market. And talk to a financial planner if you have any questions.

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