Negative Interest Rates

My crude attempt at understanding negative interest rates.

Negative, but interesting

Negative interest rates are the thing that every central bank has in their pocket, but doesn’t want to use. It pisses off anybody holding the country’s currency or looking for a steady bond yield.

Negative interest is something that I’ve always been curious about, but never understood at a deeper level. Time to ask some questions.

Does a negative funds rate translate to negative lending terms for commercial banks?

Let me debunk a common misconception about negative interest rates. Some people assume that a commercial bank would engage in lending with a negative advertised interest rate.

Short answer: absolutely not.

Even low, non-zero interest rates can threaten the profitability of lending institutions.

The negative interest rates that you hear about in the news are actually “deposit rates” that are set by central banks. These rates signify how much interest a bank can earn when holding reserves with the central bank. So, when we talk about lending terms, we are referring to a “real interest rate”.

What’s the difference between real interest rates and target rates?

There are actually three distinct concepts in play:

  • Real interest rates: This is the nominal interest rate (i.e. the publicly advertised interest rate) minus the rate of inflation. It represents the actual purchasing power of the money earned through the interest rate.
  • Target interest rates: This is the interest rate set by a central bank for commercial banks to borrow from the central bank. Lowering target interest rates is a common tool used by central banks to stimulate economic activity by making capital access easier for commercial banks, which in turn should lead to more lending and more economic activity.
  • Commercial interest rates: This is the interest rate that a borrower pays on a loan from a commercial bank. It is typically higher than the target interest rate set by the central bank, as commercial banks need to earn a profit on the loans they make.

In short, the real interest rate is the purchasing power of the interest rate earned or paid, while target interest rates and commercial interest rates are related to the cost of borrowing and lending money.

Lower target interest rates set by central banks can lead to lower commercial interest rates, making borrowing cheaper for businesses and individuals.

However, commercial banks need to earn a profit on their lending, so the commercial interest rate will still be higher than the target interest rate.

Why would a commercial bank hold excess reserves with a central bank?

Commercial banks typically hold excess reserves with the central bank, and they earn interest on these reserves. The alternative would be to use the excess cash to earn a yield elsewhere (investing, lending, etc).

However, if interest rates become negative, the central bank deposit yields also become negative. Consequently, commercial banks are charged if they hold any more liquidity than is necessary to back up their customer withdrawals, rather than being incentivized to hold excess reserves in the central bank.

The only way for a commercial bank to avoid this charge is to withdraw their excess reserves and start lending.

Negative rates really means negative deposit rates.

Why would a central bank do this in the first place?

If your economy has weak growth and your currency is rapidly appreciating relative to other currencies, then a central bank response might look like:

  • Reduce interest rates.
  • Wait for lending activity to increase, based on more favorable rates.
  • Wait for secondary economic effects (productivity increases) from this lending.

The ultimate intention of lowering interest rates to negative levels is to encourage commercial banks to lend to third parties, while simultaneously penalizing them for retaining excess funds. It is important to note that the benefits of negative interest rates largely depend on how productively the capital is allocated, which is a separate topic altogether.

Has any central bank actually implemented this?


Several countries have implemented negative interest rates as a fundamental aspect of their monetary policy.

For instance, in 2016, the Bank of Japan implemented a negative target rate on new central bank deposits.

Likewise, the Swiss National Bank maintained negative interest rates for a significant duration, from 2015 until recently.

What are the effects on the Japanese economy? (2016 - present)

When the Bank of Japan introduced its new deposit policy in 2016, many Japanese commercial banks chose to use their cash and invest in low-risk assets, rather than using the funds for lending. This decision stemmed from the persistently weak demand for borrowing and prolonged deflation, which made it difficult for these banks to secure attractive loan terms denominated in JPY (¥).

Moreover, Japanese banks are facing a number of challenges that make lending difficult. The country's aging population and declining birth rate mean that there were fewer borrowers in the market, while stringent lending standards and tight regulations make it harder for businesses to qualify for loans.

Add in a large amount of delinquent loans on the books, and you have a horrible lending environment.

As a result, Japanese banks invested a significant portion of their excess reserves into low-risk assets such as government bonds, which offered low yields but were considered relatively safe investments. While this reduced the amount of reserves held by banks, it did not lead to significant economic growth or inflation, as the funds were not being used productively to stimulate the economy.

To summarize why I feel bad for the Bank of Japan, here’s what they’re up against:

  • Increased competition in lending (fintech startups, lending firms). Older, more risk-averse firms are unwilling to compete.
  • Persistently weak demand for borrowing. Older people are not borrowing, and younger people don’t have credit scores or collateral to meaningfully borrow.
  • Prolonged currency deflation. With increased purchasing power, people get more for less from businesses.
  • An aging population and a declining birth rate. Much like their interest rates, the birth rate is also negative.
  • Stringent lending standards. I don’t claim to be familiar with this, but Japan favors long-term lending relationships and has high standards for creditworthiness.
  • Large amount of delinquent loans on the books. This is why older firms are more risk-averse.

What are the effects on the Swiss economy? (2015 - 2022)

Another example: Switzerland in 2015. Switzerland’s central bank (SNB) moved to negative target interest rates, specifically -0.75%.

The rationale for doing so was to prevent excessive deflation of the Swiss franc relative to other currencies, especially ones that belonged to key trade partners. In this case, a strong currency hurt Switzerland's export pricing, in addition to its tourism industry. Swiss businesses made it a key issue to resolve the strong franc, as it threatened their businesses ability to compete with exporters from other countries.

Switzerland’s central bank was enacting an attempt to stifle its own currency. By introducing negative interest rates, they hoped to encourage investors to get out of holding the Swiss franc, and invest in other assets and currencies.

Similar to Japan, Switzerland was also trying to stimulate economic activity by providing more favorable terms for accessing capital.

In the years that followed, the Swiss franc was weakened and export volume was boosted. However, like Japan, profitability crunches were placed on sovereign commercial banks at a bad time, forcing their spare cash into yield-bearing assets rather than unfavorable lending terms.

In 2022, Switzerland graduated back into positive target interest rates. Purportedly, the Swiss government has made billions in revenue on commercial bank deposits.

Why would you buy government bonds with a negative yield?

This would only truly happen in dire circumstances, when markets are extremely risky: enough so that a buyer would be willing to pay to lend money to the bond issuer rather than earn interest.

I’m aware of two countries that have issued negative interest-rate bonds: Switzerland and Germany. Apparently, Nestle even issued a negative yield bond in 2019.

While all of these bonds have fixed maturity dates, the interest rates are not always fixed. An investor might hope to buy a bond with the hope that yields would increase (and thus the interest payments and market price of the bond).

What happens to asset prices?

This is hard to assess, since weak economic growth and deflation contribute to underlying price movements. Funny enough, these are the exact problems that negative interest rates aim to solve.

This is what central banks want to happen. The target currency is what denominates debts and trade in that country.

If we assume, that negative interests rates work as implemented: stock prices would intuitively increase, as the economy has been improved and inflation is rising. At the same time, if the policy doesn’t work as implemented, stock prices may remain low as investors and lending institutions become more risk-averse.

Bond prices usually rise, as people quickly flock to existing bonds with higher yield rates, and buy them at a premium to the new “negative” coupon rate.

The yield curve of fixed-interest bonds would tend to invert, since investor sentiment is aligned with short-term bonds closer to maturity (higher yield rates) than the newer long-term bonds.

There’s not much reason to buy new fixed-rate bonds or hold excess cash, unless the alternatives are worse. Sometimes they are.

If the interest rates are targeted at debt denominated in a currency that you hold, it could be unwise to hold on to that cash. The counterpoint to getting rid of your currency would be the case of Switzerland in 2015. The relative purchasing power of the Swiss franc still rose despite the Swiss National Bank’s best efforts to turn deflation into inflation.

What should I take from this?

Negative interest rates are implemented to:

  • Encourage inflation, or at least dampen deflation.
  • Encourage lending and spur on new economic growth.

Multiple central banks (Swiss National Bank, Bank of Japan) have implemented negative interest rates with mixed results.

If you live in the US as of writing (2023), negative interest rates aren’t coming anytime soon.

Here are some suggestions for topics to explore if you’re interested:

  • The potential risks and drawbacks of negative interest rates, in relation to asset bubbles and economic instability.
  • The impact of negative interest rates on different sectors of the economy not discussed here (eg: real estate, technology).
  • The relationship between negative interest rates and quantitative easing (QE) policies.
  • A comparison of negative interest rates with other unconventional monetary policies, such as helicopter money or debt monetization.
  • The role of negative interest rates in the global economy and their potential impact on international trade and relations.