Negative interest rates

Negative interest rates are one of the more unusual tools some central banks have used, but they are not something policymakers reach for casually. They can frustrate banks, savers, and investors 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.

Let me debunk a common misconception about negative interest rates. Some people assume that the main idea is for commercial banks to advertise normal loans with negative interest rates.

Short answer: usually not.

There have been edge cases of negative-rate mortgages or loans, especially where floating-rate benchmarks and fees create unusual outcomes. But that is not the main policy mechanism people usually mean.

The negative interest rates that you hear about in the news are often central-bank deposit or reserve rates. These rates determine how much interest a commercial bank earns, or pays, when holding reserves with the central bank. Negative rates can also show up in money markets and bond yields, but the central-bank deposit rate is the usual starting point.

There are actually three distinct concepts in play:

Real interest rates: This is the nominal interest rate minus inflation, usually expected inflation when people are making forward-looking decisions. It represents the purchasing-power-adjusted return from saving or the purchasing-power-adjusted cost of borrowing.

Policy rates: These are the interest rates set or targeted by a central bank. Depending on the country, this could mean an overnight interbank target, a deposit facility rate, a repo/refinancing rate, or the rate paid on some portion of bank reserves.

Commercial interest rates: These are the interest rates that borrowers pay on loans from commercial banks. They are shaped by policy rates, credit risk, collateral, competition, maturity, regulation, and the bank’s desired profit margin.

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 policy rates can lead to lower commercial interest rates, making borrowing cheaper for businesses and individuals.

However, commercial banks still need to manage risk and earn a profit, so private lending rates usually remain above the safest short-term policy rates, especially for unsecured or risky borrowers.

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 central-bank deposit rates become negative, some reserve balances can become costly to hold. Consequently, commercial banks may be charged for holding more reserves than necessary, depending on the exact tiering system used by the central bank.

One important caveat: banks cannot collectively make reserves disappear by lending more. An individual bank can reduce its own reserve balance by buying assets, making loans, or shifting funds elsewhere, but those reserves usually end up at another bank. Systemwide reserves only really fall if the central bank drains them, or if reserves are converted into physical cash.

So negative rates are best understood as a penalty on certain reserve balances, intended to change incentives at the margin.

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 policy rates. Hope lending, investment, or asset purchases increase because safe returns are less attractive. Hope for secondary economic effects from this activity, such as stronger demand, higher inflation, or more productive investment.

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.

Certainly.

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

For instance, in 2016, the Bank of Japan introduced a negative rate on part of commercial banks’ policy-rate balances at the central bank.

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

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 face a number of challenges that make lending difficult. The country's aging population and declining birth rate can reduce borrower demand, while lending standards and regulation can make it harder for some businesses to qualify for loans.

Add in the long shadow of Japan’s earlier banking problems after the asset bubble, and you have a difficult 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 low inflation or price deflation. With increased purchasing power, people get more for less from businesses. An aging population and a declining birth rate. Fewer young households and firms can mean fewer natural borrowers. 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. The legacy of earlier bad loans. This is part of why older firms may be more risk-averse.

Another example: Switzerland in 2015. Switzerland’s central bank (SNB) moved its deposit rate to -0.75%.

The rationale for doing so was to prevent excessive appreciation 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 policy helped lean against franc appreciation, though the currency remained strong and the overall export impact is hard to isolate. However, like Japan, negative rates also pressured domestic bank profitability and encouraged banks and investors to look for yield elsewhere.

In 2022, Switzerland moved back into positive policy rates. The SNB also earned significant income from negative interest charged on commercial-bank sight deposits, though calling this straightforward government revenue would be too imprecise.

This can happen when investors value safety, liquidity, regulatory treatment, or currency exposure enough that they are willing to accept a negative yield to maturity.

Several countries have had negative-yielding sovereign bonds, including Switzerland, Germany, Japan, Denmark, and others. Nestlé also issued a notable negative-yield bond in 2015.

A bond can have a positive coupon and still trade at a negative yield if investors bid its price high enough. An investor buying a bond might hope yields fall further, because when yields fall, existing bond prices rise. The reverse is also true: when yields rise, existing bond prices fall.

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 interest rates work as intended, stock prices might increase as discount rates fall, credit becomes easier, and growth or inflation expectations improve. At the same time, if the policy doesn’t work as intended, stock prices may remain low as investors and lending institutions become more risk-averse.

Bond prices often rise when policy rates fall, as people flock to existing bonds with higher coupons and bid them up relative to newly issued lower-yielding bonds.

The yield curve does not automatically invert under negative rates. Its shape depends on expectations for future growth, inflation, central-bank policy, and risk premia.

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.

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.