How Negative Interest Rates Work

The idea of negative interest rates may seem counterintuitive, if not downright crazy. In a world where lenders make money by charging their customers interest, why would they be willing to pay someone to borrow money? In this case, the lender is the one taking the risk of defaulting on the loan. As strange as it may seem, 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.

What Are Negative Interest Rates?

An interest rate is the cost of borrowing. Financial institutions charge borrowers interest when they lend money. So taking a car loan, mortgage, line of credit, student loan, credit card, or any other debt means you'll pay interest. This means a 2% annualized interest rate on a $100 loan means that the borrower must repay the initial loan amount plus an additional $2 after one full year. Banks and central banks charge interest when they lend money to other institutions, too.

There are cases when interest rates dip below 0%. These are called negative interest rates. This happens during periods of deflation. During deflationary periods, the value of a nation's currency rises because of a drop in prices.

When this happens, central banks may have to set interest rates into negative territory. This means that borrowers may be credited interest rather than having to pay it. For instance, a -2% interest rate means the bank from the example above pays the borrower $2 after a year of using the $100 loan instead of the other way around.

Negative Interest Rates in Practice

Negative interest rates are an unconventional monetary policy tool. They are also fairly new:

• Sweden's central bank was the first to deploy them in July 2009, when 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 also opted to offer negative interest rates, resulting in $9.5 trillion worth of government debt carrying negative yields in 2017.

But 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 further weaken the economy, as a lack of spending causes further job losses, lowers profits, and prices to drop. All of this reinforces people’s fears, giving them even more incentive to hoard their money. 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 want to avoid with negative interest rates, which not only affects bank loans but also bank deposits.

The Theory Behind Negative Interest Rates

Cash deposited at a bank yields a storage charge when interest rates dip into negative territory. So depositors don't earn any interest income when they save their money but pay money to do so. 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 turned to negative interest rates is to lower the value of the euro. Low or negative yields on European debt may 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 is liable to stimulate demand for exports and, hopefully, encourage businesses to expand.

Risks of Negative Interest Rates

Negative interest rates should help to stimulate economic activity and stave off inflation. However, some policymakers remain cautious about resorting to them because there are several ways they could backfire.

Consider what happens with certain assets like mortgages. These loans are contractually tied to the prevailing interest rate, which means that negative rates could squeeze profit margins to the point where banks lend less.

There is also nothing to stop deposit holders from withdrawing their money and stuffing the physical cash in mattresses because saving and storing their money at banks would come at a cost. 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.

The Bottom Line

While negative interest rates may seem paradoxical, this apparent intuition has not prevented some European and Asian central banks from adopting them. This is evidence of the dire situation that policymakers believe characterizes the European economy.

When the Eurozone inflation rate dropped into deflationary territory at -0.5% in Mar. 2015, European policymakers promised to do whatever it took to avoid a deflationary spiral. However, even as Europe entered unchartered monetary territory, many analysts warned that negative interest rate policies could have severe unintended consequences.