Below Zero: The Curious Case of Negative Interest Rates
For most of this book, we've operated under a fundamental assumption, one that aligns with centuries of economic practice and everyday intuition: interest rates are positive. Lenders expect compensation for parting with their money, and borrowers expect to pay a price for accessing funds. The idea that someone would pay you to borrow their money, or that you would have to pay a bank simply to hold your savings, seems utterly backwards – a financial world turned upside down. Yet, in the years following the global financial crisis of 2008, this seemingly bizarre scenario became a reality in several major economies. Central banks deliberately pushed their key policy rates below zero, venturing into the curious and controversial territory of negative interest rates.
This wasn't merely a theoretical exercise contemplated in academic papers; it was an active policy tool deployed by institutions like the European Central Bank (ECB), the Bank of Japan (BoJ), the Swiss National Bank (SNB), and Sweden's Riksbank. Their journey below zero marked a significant departure from conventional monetary policy and raised profound questions about the limits of central banking, the behaviour of financial institutions, and the very nature of money in the modern economy. Understanding this phenomenon requires setting aside conventional wisdom and exploring why policymakers felt compelled to take such an unconventional step.
The primary motivation behind adopting Negative Interest Rate Policy (NIRP) stemmed from the challenges faced when traditional monetary policy tools proved insufficient. As discussed in Chapter Six, central banks typically combat economic downturns by lowering their target interest rates to encourage borrowing and spending. However, during severe recessions or periods of stubbornly low inflation (or even deflation), central banks might cut their policy rates all the way down to zero. Historically, zero was often considered the floor, the "zero lower bound" (ZLB), beyond which conventional rate cuts couldn't go. After all, who would lend money if they had to pay for the privilege, when holding physical cash seemingly offered a zero return?
Yet, in the face of persistent economic weakness, deflationary risks, and sluggish credit growth even with policy rates at zero, some central banks felt the need for additional stimulus. The logic behind NIRP was essentially an attempt to push slightly below that perceived zero lower bound. The aim was multifaceted: to further lower borrowing costs throughout the economy, to encourage banks to lend out their excess reserves rather than hoard them, to stimulate spending and investment over saving, and, in some cases, to combat unwanted currency appreciation. It represented an unconventional tool deployed when the conventional toolkit seemed exhausted.
How does NIRP work in practice? It's crucial to understand that negative interest rates, as implemented by central banks, typically apply very specifically. They don't usually mean that your personal mortgage lender will start paying you interest each month, nor (in most cases) that your neighbourhood bank will charge you a fee equivalent to a negative rate simply for holding your savings account balance. Instead, the negative rate is primarily applied to the reserves that commercial banks hold at the central bank.
Recall from Chapter Seven that central banks use tools like Interest on Reserve Balances (IORB) to influence their policy rate. In a NIRP regime, the central bank flips this concept on its head. Instead of paying banks interest on their reserves, the central bank charges them a fee for holding reserves above a certain threshold. For example, the ECB introduced a negative rate on its "deposit facility," effectively taxing banks for parking excess liquidity overnight at the central bank. Similarly, the BoJ and SNB applied negative rates to portions of commercial banks' reserve balances.
The intended mechanism was to alter banks' incentives. Faced with a penalty for holding idle reserves, banks would theoretically be more motivated to lend that money out to businesses and households, even at very low positive rates, rather than pay the central bank. This increased willingness to lend, combined with the generally lower market rates fostered by NIRP, was hoped to stimulate credit creation, investment, and economic activity. It was also intended to encourage banks and investors to seek higher returns elsewhere, potentially including investments abroad, which could help weaken the domestic currency – a desirable outcome for countries battling deflation or trying to boost exports.
The experience of central banks that implemented NIRP varied. The ECB first went negative in 2014, partly to combat deflationary risks in the Eurozone. The SNB used negative rates starting in late 2014 primarily to counter strong appreciation pressure on the Swiss franc, which was hurting Swiss exporters. The BoJ adopted NIRP in early 2016 as part of its broader package of measures aimed at overcoming decades of deflation and stagnant growth. Sweden's Riksbank also experimented with negative rates. Each implementation had its nuances, often involving tiered systems where the negative rate only applied to reserves above a certain level, aiming to mitigate the overall burden on the banking sector.
The impact on commercial banks was perhaps the most direct and widely debated consequence of NIRP. Charging banks for holding reserves directly squeezed their profitability. Banks earn money primarily through their net interest margin – the difference between the interest they earn on loans and assets, and the interest they pay on deposits and other funding. Negative policy rates put downward pressure on the rates banks could charge on loans, while banks found it extremely difficult, both commercially and politically, to pass those negative rates onto their retail depositors.
Most banks were reluctant to impose negative rates on ordinary household savings accounts, fearing a backlash and mass withdrawals as customers opted to hold physical cash instead. While some banks did apply negative rates to very large corporate or institutional deposits, the vast majority of retail savings remained shielded, earning zero or very slightly positive nominal rates. This asymmetry – banks paying a penalty on reserves but unable to charge depositors – compressed their net interest margins, potentially eroding their profits and, counterintuitively, possibly even reducing their capacity or willingness to lend if their capital base weakened.
To counteract this pressure on profitability, some banks responded by increasing fees on other services, such as account maintenance, transactions, or advisory services. The net effect on overall bank lending due to NIRP remains a subject of economic research and debate, with some studies suggesting a modest positive impact on credit supply, while others highlight the negative consequences for bank profitability potentially offsetting the intended stimulus. Recognizing the burden, central banks like the ECB implemented tiering systems, exempting a portion of banks' reserves from the negative rate to lessen the overall cost to the banking sector.
For savers, the era of negative policy rates generally meant an environment of extremely low, often near-zero, returns on safe assets like savings accounts and short-term government bonds. While most retail savers didn't face explicitly negative deposit rates, the returns offered were often well below the rate of inflation, resulting in negative real returns (as discussed in Chapter Eighteen). This environment strongly discouraged traditional saving in banks and pushed savers, including large institutional investors like pension funds and insurance companies, further out on the risk spectrum in search of higher yields. This "search for yield" phenomenon was arguably intensified by NIRP, potentially contributing to higher valuations in assets like stocks, corporate bonds, and real estate.
Borrowers, on the other hand, theoretically stood to benefit from the ultralow interest rates fostered by NIRP. The policy aimed to reduce borrowing costs for mortgages, business loans, and consumer credit. Indeed, mortgage rates in countries with NIRP fell to historically low levels. In some extraordinary cases, particularly in Denmark where mortgage rates are closely linked to bond market yields, some borrowers experienced briefly negative effective mortgage rates after accounting for fees, meaning the outstanding loan balance decreased by slightly more than the amount they paid each month. However, widely available negative-rate loans for consumers remained rare exceptions rather than the rule. For businesses, the lower cost of capital potentially made more investment projects viable, although the actual impact on investment depended heavily on business confidence and demand expectations.
The impact on financial markets, particularly the bond market, was profound. Negative policy rates directly pulled down yields across the short end of the yield curve. Remarkably, yields on highly-rated government bonds from countries like Germany, Switzerland, and Japan frequently traded in negative territory, sometimes even for maturities extending out several years. What does a negative bond yield mean? It implies that an investor buying such a bond and holding it to maturity would receive back less money in total (coupon payments plus principal) than they initially paid for the bond.
Why would anyone buy a bond guaranteed to lose money in nominal terms? Several reasons exist. Some institutional investors (like pension funds or insurance companies) might be required by regulations or mandates to hold a certain amount of high-quality government bonds, regardless of yield. Others might view these bonds as an extremely safe place to park large sums of cash, potentially safer or more convenient than holding physical currency, especially if they expect rates to fall even further (which would generate capital gains on the negative-yielding bond). For investors in countries with negative deposit rates on large institutional accounts, a slightly negative bond yield might still be preferable. Speculators might also buy negative-yielding bonds hoping to sell them at an even higher price (and thus even more negative yield) to someone else later. The existence of trillions of dollars worth of negative-yielding debt became one of the defining, and often perplexing, features of the post-crisis financial landscape.
The effectiveness of NIRP in achieving its macroeconomic goals – boosting inflation and stimulating growth – remains controversial. Some proponents argue it provided modest but necessary additional stimulus when other options were limited, helping to lower borrowing costs, manage exchange rates, and avert deeper deflation. They point to studies suggesting positive effects on bank lending, particularly in the Eurozone.
Critics, however, raise concerns about the negative side effects. The squeeze on bank profitability is a major worry, potentially hindering the transmission of monetary policy in the long run. The impact on savers and institutions like pension funds, which rely on generating returns from safe assets, is another significant concern. Furthermore, some argue that ultralow and negative rates encourage excessive risk-taking and contribute to the formation of asset bubbles, storing up potential problems for the future. The psychological impact of negative rates – potentially signalling desperation by the central bank or confusing the public – is also cited as a drawback.
A fundamental question surrounding NIRP is the existence of an effective lower bound (ELB) on nominal interest rates. While central banks demonstrated that the ZLB wasn't an absolute floor, there is still likely a limit to how far rates can practically fall below zero. The main constraint is the existence of physical cash, which offers a guaranteed nominal return of zero (albeit with storage costs and security risks). If interest rates on bank deposits were to become significantly negative – say, -2% or -3% – individuals and businesses might find it worthwhile to withdraw their money from the banking system and simply hoard physical currency. This potential for mass cash withdrawals limits how far central banks can push rates into negative territory without destabilizing the financial system. The precise location of the ELB is uncertain and likely varies depending on factors like the costs of storing and insuring cash, but it's generally thought to be slightly, rather than dramatically, below zero.
This physical constraint has fueled discussions about the future of money and monetary policy, including proposals for central bank digital currencies (CBDCs). Some proponents argue that if physical cash were eliminated or its use restricted, central banks could potentially push nominal interest rates much further into negative territory if needed, overcoming the ELB. However, the societal and political implications of eliminating cash are vast and highly contentious.
Was negative interest rate policy a temporary emergency measure born of extraordinary circumstances, or has it become a permanent addition to the central banker's toolkit for future downturns? The debate continues. Several central banks that implemented NIRP have since moved their policy rates back to zero or into positive territory as economic conditions improved or inflation surged. However, the experience demonstrated that zero is not an insurmountable barrier. Should future crises push economies towards deflationary traps, the option of revisiting negative rates, despite its complexities and controversies, might remain on the table. The curious case of negative interest rates serves as a potent reminder that the world of monetary policy is constantly evolving, and the seemingly simple concept of the price of money can behave in unexpected and profoundly counterintuitive ways.