Negative Interest Rates - Definition and How They Work - Bankrate

10/24/2020 Negative Interest Rates: Definition and How They Work | Bankrate
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Negative interest rates, explained — and

how they work
By Sarah Foster
Jul. 3, 2020 / 8 min read
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I
magine a world where you pay a bank to hold onto your cash and a bank pays you
to take out a loan. This isn’t an alternate dimension — it’s what
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Negative interest rates are an unconventional economic concept that could turn the
world of banking on its head. Federal Reserve Chairman Jerome Powell has repeatedly
talked down the idea of below-zero borrowing costs in the U.S., though consumers may
be feeling uncomfortably close to that reality already, with bond yields tumbling to
record lows and the Fed slashing rates to zero.
Central banks in Europe and Japan have already cut into negative territory, and yields
on shorter-term Treasury bills that mature in one year or less have already dipped
below zero. But it comes with ne print: Those policies often come with mixed results
and could cause more problems than they solve.
“It’s the central bank equivalent of throwing something against the wall to see if it
sticks,” says Greg McBride, CFA, Bankrate chief nancial analyst. “That’s why negative
interest rates are not proven to be e ective. They are still nothing more than an
experiment.”
Here’s what you need to know about negative interest rates, including how they work
and how they can impact you, whether you’re a borrower, saver or investor.
What are negative interest rates?

Negative interest rates are exactly what they sound like — it’s when an interest rate
dips below 0 percent. They can come from two di erent angles: yields on bonds and
Treasury securities can go negative, as can the federal funds rate, the Fed’s main
economy-guiding lever.
That borrowing cost is a benchmark for other rates throughout the economy. When the
Fed votes to raise it, it becomes more expensive to take out a loan, slowing down
growth. When o cials decide to lower it, it becomes less expensive, propelling the
economy forward and acting as a boost to growth.
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It seems counterintuitive, but it’s not as impossible as it sounds. Government debt in
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several advanced economies are already trading in negative territory, such as Germany,
France, Denmark and the Netherlands right now. They were also once sub-zero in
Belgium.
Meanwhile, the Riksbank of Sweden, the oldest central bank in the world, was among
the rst to implement what’s now known as a negative policy rate, when it announced
in 2009 that it would charge banks to hold deposits. Technically, however, the central
bank of Denmark in 2012 became the rst to bring its key policy rate below zero. Today,
the European Central Bank’s (ECB) interest rate for deposits is minus 50 basis points,
while the Bank of Japan’s (BOJ) short-term interest rate target is minus 10 basis points.
“Negative rates have been one of the unconventional policy tools [used] since the
global nancial crisis,” says David Lebovitz, executive director and global market
strategist at J.P. Morgan Asset Management. “If you look at any traditional income
textbook, there is no mention of negative interest rates. This has been an experiment
over the course of the past decade, with the main players being people like the ECB
and the central bank of Sweden.”
How negative rates work

Negative interest rates operate in an upside-down world of banking. Instead of a bank
paying you to park your cash in a savings account or certi cate of deposit (CDs), you’ll
(theoretically) have to pay them to hold onto your cash. Think of it like a storage fee.
And instead of having to pay interest on a loan if you go out and buy a car, you’ll
(supposedly) earn a little bit of money with negative rates.
“It ips the banking model on its head,” McBride says.
Negative rates for consumers wouldn’t just one day happen on its own. It’d likely be
determined based on the interest rate that the Fed sets: the federal funds rate. If
o cials decided to cut that benchmark borrowing cost, they’d then elect to charge
banks a fee for parking their reserves in accounts at the Fed. Banks would then pass
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that policy rate on to consumer products, meaning it’d get ltered through to the rest of
the economy.
“A negative rate means you are more concerned with the return of capital rather than
the return on capital,” Lebovitz says.
That’s only part of the picture. Bond yields can also o er a negative net return, with or
without the Fed’s help. To explain why, it’s important to remember how bond yields
generally work: When prices rise, the return that they generate falls, meaning
heightened demand could push yields below 0 percent. But technically speaking, a
negative-yielding bond is simply one that gives back less money than what was spent
on the initial investment.
“A negative bond yield doesn’t mean that the lender has to pay the borrower a coupon
rate,” McBride says. “It just means that the price has been bid so high that even with
the coupon income over the life of the bond, you still are not going to make a pro t
when you get your principal back at maturity.”
What’s the purpose of negative rates?

Central banks and other countries have introduced negative interest rates for a variety
of reasons — mainly reserving them for the most desperate of times, economically
speaking. They’ve been touted as methods to spur intense borrowing and spending, to
push in ation back up to target and to devalue a country’s currency, boosting trade.
Coming out of the Great Recession, central banks around the world were struggling to
revive their economies. While the Fed slashed rates to zero and instituted a massive
bond-buying program to push down longer-term rates, the ECB and BOJ set their
sights on something more.
Fearing a de ationary trap, these central banks started betting that negative rates
would spur intense levels of borrowing and spending. After all, why would a consumer
prefer to keep their money in an account at a bank, when they could be borrowing
money and making a pro t? And why would a bank not lend out to businesses and
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“The idea of bringing policy rates and interest rates broadly into negative territory is
really to stimulate the ow of credit and to essentially encourage risk-taking on the part
of consumers and investors,” Lebovitz says. “It’s meant to incentivize people to borrow
money and take more risk.”
Even trickier, o cials theorized that negative rates could devalue the country’s
currency. It would push foreign investors out and cause an uptick in demand for the
country’s exports. That’s been a major talking point for President Donald Trump — one
of the main reasons why he pressured o cials throughout 2019 to reduce rates to “zero
or lower.”
What are the major consequences of negative rates?

Experts say negative interest rates don’t always lead to the outcomes economic theory
would suggest, stirring up concerns of bank runs and pro tability if they’re ever
implemented.
Lenders want to be compensated for loaning out to a potentially risky borrower. That
means if yields were to turn negative, it’d be unlikely for you to get paid to take out
something like a mortgage or an auto loan, and even more so, banks might not want to
write out those loans, McBride says.
“They don’t want to do it from a business perspective,” McBride says. “Rates might be
low, but it doesn’t eliminate the risk of lending.”
But in theory, lower-risk borrowers might be able to get away with taking out a loan at a
modesty negative rate, which occurred in Switzerland, says Bill English, nance
professor at the Yale School of Management who spent more than 20 years at the Fed.
Lenders also make money o of interest rates. Such a policy could squeeze their
pro ts, ultimately deterring them from lending even more, which could then needlessly
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slow down the economy. That’s been the case in the current countries where negative
rates have taken hold.
There’s also a clear concern that negative yielding consumer products could cause bank
runs. People might prefer to keep their money under their mattress, where the interest
rate is at least 0 percent. That’s made banks all the more reluctant to pass on negative
rates.
Another concern is that a too-low negative federal funds rate could discourage banks
from keeping deposits at the Fed, English says. Instead, they could opt to convert their
reserves to currency, which could strain the nancial system. Experts often call this a
“reversal rate.”
And just as it was di cult for the Fed to hike rates in 2018 during a time of solid
economic growth, it’s hard to shake the negative interest rate cycle once it begins. The
ECB, BOJ and Bank of Switzerland are still in the negative zone, despite the recession
ending more than a decade ago. Experts say their economies aren’t in any better shape
now than before those policies were implemented.
“If the demand materialized and you saw credit owing through the economy, you
could move interest rates back out of negative territory,” Lebovitz says. “Now, they’re
stuck with negative rates. We’ve seen them throw their hands in the air and say, ‘This
isn’t really boosting in ation and reviving economic growth by increasing risk taking.’”
Other former and current central bankers have also warned about potential economic
woes, mainly on the grounds that there isn’t enough research to suggest whether
negative rates could help.
The Fed doesn’t “want to take a chance by undermining pro tability in the banking
sector or moving rates into negative territory without proof” that it could work, says
Lebovitz. “They would really need to be out of bullets and grasping at straws.”

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How negative rates would impact you

It doesn’t look like negative interest rates will be happening in the U.S. anytime soon.
Still, if things got really bad, English says he could imagine the Fed changing its tune.
If that happens, individuals who are saving or living o xed income would be left
behind, just as savers and retirees haven’t bene ted from more than a decade of ultra-
low rates.
“Think about what you’re getting paid on your checking account today, and imagine
relying on that to fund your day-to-day activities,” Lebovitz says. “If you think zero rates
are causing a problem for folks like that, negative rates are going to exacerbate it.”
Banks, however, are more likely to charge customers fees rather than an outwardly
negative interest rate because it’s easier to communicate, says Gary Zimmerman,
founder and CEO of MaxMyInterest.com. And the larger the balance, the less a bank
will want your money. Firms are swimming in deposits and struggling to nd pro table,
reliable avenues of lending, meaning they’ll be forced to turn around and park those
funds back at the Fed for a cost.
“The whole intent of negative interest rates would be to incentivize banks to turn
around and lend the money,” Zimmerman says. “But the problem is, there just aren’t
enough good lending opportunities.”
But bondholders of negative yields seem to believe there’s a way to game the system.
Buying a sub-zero bond and holding it until maturity is a guaranteed way to lose money,
but if you sell it as prices continue to rise, you’ll end up making more cash while also
holding onto a safe-haven investment.
“People buying bonds at negative rates, they’re gambling that the rate is going to go
lower,” McBride says. “If they hold it to maturity, they’re going to guarantee a loss.”
The bottom line is, consumers won’t bene t from this policy, McBride
says. Continue
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under your mattress, he says.
“It’s federally insured, and you’re completely protected from loss,” McBride says. “You
put that money under the mattress, you’re in no protection against loss or theft.”
Learn more:
The repo market, explained — and why the Fed keeps pumping hundreds of billions
into it
No, the Fed cutting rates to zero will not lead to 0% mortgage rates
8 best low-risk investments
Featured image by Mark Wilson of Getty Images.
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10/24/2020 Negative Interest Rates: Definition and How They Work | Bankrate

FEDERAL RESERVE Advertiser Disclosure

Negative interest rates, explained — and

Learn more. Accept Cookies

What are negative interest rates?

How negative rates work

“It ips the banking model on its head,” McBride says.

What’s the purpose of negative rates?

Learn more. Accept Cookies

What are the major consequences of negative rates?

How negative rates would impact you

Learn more. Accept Cookies

8 best low-risk investments

Featured image by Mark Wilson of Getty Images.

You may also like

Learn more. Accept Cookies

What is quantitative easing?

Fed cuts rates by quarter point, split on further reductions

Learn more. Accept Cookies

5 ways the Fed’s interest rate decisions impact you

Press room Compare rates

Careers Latest news

Advertise with us Popular topics

Site map Glossary

Privacy policy / California privacy policy

Do not sell my info

Understanding Bankrate’s averages

GLBA annual notice

How we make money Cookie Settings

Bankrate.com does not include all companies or all available products.

Bankrate, LLC NMLS ID# 1427381 | NMLS Consumer Access

© 2020 Bankrate, LLC. A Red Ventures company. All Rights Reserved.

Learn more. Accept Cookies

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