Up Front

The Hutchins Center Explains: Negative interest rates

David Wessel and Peter Olson

The Federal Reserve cut short-term interest rates nearly to zero in December 2008, and kept them there for seven years. But the European Central Bank and national central banks in Japan, Sweden, Denmark and Switzerland took their benchmark rates below zero, a phenomenon called “negative interest rates.” It sounds weird and it’s unusual. And there’s occasional speculation that the Fed might resort to negative rates if the economy deteriorates. Here’s a primer.

What are negative rates?

In ordinary times, if an individual or company borrows from a bank, it promises to pay the money back with interest. When rates are negative, however, the bank pays the borrower, meaning the bank ends up with less than it lent in the first place. So far there are not many instances where individuals are getting charged to deposit money or getting paid to borrow it, but in several countries banks are being charged to store excess funds at their central bank. In other words, commercial banks have to pay the central bank if they want to park money there.

Why would a central bank want interest rates to go negative?

During economic downturns, central banks often lower rates to stimulate growth or, in some circumstances, to raise the inflation rate. Until recently, it was thought that rates couldn’t go below zero because people would hold on to cash instead of paying a fee to deposit it. It turns out this was not quite right. (See the next question for why.) Now that central banks know rates can go negative, many are pushing them in that direction for the same reason they lowered them to zero in the first place—to provide stimulus and, where inflation is below target, to raise the inflation rate. The thinking is that negative rates will provide even more incentive for private banks to make loans. What might have looked like a project not worth funding even in a low-interest-rate environment might now look attractive if the alternative is being charged to store money at the central bank or holding lots of cash.

In other instances, central banks turn to negative rates to lower their exchange rates and make their exports more competitive, another way to stimulate growth. Here’s how that works: Lower rates on a country’s bonds mean less demand. The less demand for a country’s bonds, the less demand for its currency and, thus, a decline in its price, the exchange rate. That, in turn, makes a country’s exports more attractive to foreign consumers. Rising exchange rates were the immediate impetus for Switzerland and Denmark when their policy rates went negative.

Wouldn’t someone just hold cash instead of paying a fee to lend money?

Yes, but holding cash isn’t free. For large sums of cash, you’d want a safe, a security system, and so forth. It turns out that at modestly negative interest rates—say, minus 0.5%—there’s not much appetite for holding cash. Stephen Cecchetti and Kermit Schoenholtz have observed that “at the negative rates that we have seen so far, cash in circulation has not spiked.”

Is this a new idea?

No. The concept was contemplated at least as far back as the early 20th century by Silvio Gesell, whom prominent British economist John Maynard Keynes called “a strange, unduly neglected prophet.” Gesell proposed effectively taxing currency by requiring that it be stamped each week—for a fee—to maintain usability, which amounts to a negative interest rate on cash.

Renewed attention to negative rates has surprised many economists, including Paul Krugman, who wrote in 2015: “I am pinching myself at the realization that this seemingly whimsical and arcane discussion is turning out to have real policy significance.” (In 2011, he had stated negative policy rates “can’t happen.”)

How widespread are negative rates?

Several central banks have pushed their policy rates negative, including two big ones: The European Central Bank in June of 2014, and the Bank of Japan in January of 2016. The others are the central banks of Denmark (2012), Switzerland (2014), and Sweden (2015). For more, see this table showing when and why each bank went negative.

Partially as a result of this and interest rate declines generally, many countries (France, Austria, Finland, the Netherlands, Germany, etc.) have sold government bonds at negative yields.

How exactly does this work?

Most banks follow the same basic approach. Commercial banks are required to hold reserves at the central bank, but have the option of holding more than is necessary. Under a negative rate structure, commercial banks typically are paid a small amount of interest or zero interest on their required reserves, but have to pay interest on everything above that.

However, the details vary. For example, Japan has three rates—one positive, one zero, and one negative. The Bank of Japan also charges banks negative interest rates on cash they hold in their vaults if that cash was withdrawn from their central bank accounts but not loaned out. (It wants negative rates to encourage lending, not just induce cash shifting from the central bank to individual bank’s vaults.)

How low can policy rates go?

A 2010 Federal Reserve memo put it at somewhere around minus 0.3% in the U.S., but noted that was only a rough estimate. Economists at J.P. Morgan Chase more recently argued the bound was -1.30%. According to James McAndrews, head of Research at the NY Fed, “There is no simple answer.”

Of course, if you get rid of paper currency and move to an entirely digital system, as some have proposed, there would appear to be no limit to how low rates could go because people could no longer just switch to zero-interest-earning cash.

What obstacles must the Fed overcome before implementing negative rates?

There are several. In the U.S., one is legal. As former Fed Chair Ben Bernanke, now at Brookings, pointed out in a recent blog post, “The law says that the Fed can pay banks interest on their reserves, but it is not immediately clear whether that authority extends to ‘paying’ negative interest.” (For more, see the recent WSJ article: “Four Legal Questions the Fed Would Face If It Decided to Go Negative.”) This looks surmountable, however, at least according to Miles Kimball, who is researching the issue with legal scholar and Fed expert Peter Conti-Brown. Their preliminary conclusion: “It looks as if the Fed might be able to do what needs to be done without any new legislation.”

The New York Fed’s McAndrews points out other difficulties in moving towards negative rates

  • Setting up new technical arrangements for bond holders to pay the issuers; 
  • Putting restrictions on when checks are cashed and other payments are made (with negative rates, it’s better for the check recipient to delay); 
  • Assessing the financial pressures on money market funds, some of which are restricted to holding short-term Treasury securities, but would find it hard to maintain that $1-per-share value and cover their expenses if rates were below zero; 
  • Making sure people don’t see the Fed’s action as confirmation it doesn’t have the ability to increase inflation, leading to price declines; 
  • Managing the political fallout since the move could be unpopular.

Commenting on the European experience, Fed Vice Chair Stanley Fischer recently noted: “negative policy rates have generally not been associated with the problems that likely were anticipated.” That it’s been pioneered elsewhere makes it appear much more likely it could work here.

Is the U.S. considering it for the future?

Not for use any time soon. Chair Yellen told Congress in February: “In light of the experience of European countries and others that have gone to negative rates, we’re taking a look at them again, because we would want to be prepared in the event that we would need (to increase) accommodation. We haven’t finished that evaluation. We need to consider the institutional context and whether they would work well here.” But in a press conference in March, she said that, given that the Fed has begun to raise rates, negative rates are “not actively a subject that we are considering or discussing.”