When you put money in a savings account, the bank pays you interest. In exchange, you allow the bank to lend out your cash to other bank customers, or borrowers.
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. However, negative interest rates don’t happen often — they are a highly unusual scenario that generally only occurs during a deep economic recession. Also, when negative interest rates do occur, they tend to impact banks more so than consumers, though consumers may be affected. Here’s a closer look at how negative interest rates work and how they’ve been used around the world.
Key Points
• Negative interest rates are an unconventional tool where banks charge savers and may pay borrowers to stimulate economic activity.
• The primary purpose is to encourage lending, spending, and combat deflationary pressures.
• Borrowers benefit by potentially receiving interest payments, which can increase spending and borrowing.
• A major risk is that savers might withdraw funds to avoid fees, leading to potential bank runs.
• Negative interest rates have shown limited success, with some countries discontinuing their use due to associated risks.
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 that 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 put money in a savings account, 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. 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 effect that helps determine how much consumers and businesses are charged to borrow. Banks set their prime rate, which is the rate they charge their most creditworthy customers for loans, based on the federal funds rate.
Negative interest rates tend to occur during deep recessions when rates are already near zero. 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 onto their customers by charging them a negative rate in turn.
When Would a Country Use a Negative Interest Rate?
When a country slips into 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, however, 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.
In addition, the ECB and BOJ were hoping to head off the threat of deflation, in which falling prices threaten to increase economic distress.
Recommended: How to Beat Inflation
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.
There is a concern that lowering interest rates 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.
Currently, there are no central banks with negative interest rates. The countries that put negative rates into place, including Japan, Denmark, and Switzerland, have since abandoned the policy.
Do Negative Interest Rates Work?
Negative interest rates present potential pitfalls. To make them work, economies have had to resort to tiered systems. In a tiered system, the negative interest rate only applies to a small portion of the reserves banks hold with the central bank, while the rest of the money earns little or no interest. This makes the charges more affordable.
Still, the question remains, 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.
Shortly after the Riksbank’s announcement, the ECB published a study that staunchly defended the use of negative rates. The study claimed that the benefits of negative rates still outweighed the potential harm raising rates would cause, even if negative rates were doubled. However, while the Riksbank agrees 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 to be more effective. And the study claims that banks have actually made more money with negative rates than they would have if rates were positive. This odd result comes from rising fees, capital gains that 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 that was caused by the novel coronavirus pandemic.
The Takeaway
When interest rates drop below 0%, known as negative interest rates, the typical relationship between the lender and the borrower gets flipped on its head. Some countries have used this tactic in an attempt to stimulate their economy, though unintended consequences can result and it’s argued whether the effects are worthwhile. Further, the back-and-forth about negative interest rates could cause confusion to investors, as well as some related stress.
Fortunately, interest rates on savings accounts in the U.S. are currently well into positive territory, particularly if you choose a high-yield account.
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