How Negative Interest Rates Work

By Matthew Johnston | Updated February 11, 2016

Interest rates are generally assumed to be the price paid to borrow money. For example, an annualized 2% interest rate on a $100 loan means that the borrower must repay the initial loan amount plus an additional $2 after one full year. On the other hand, a -2% interest rate means the bank pays the borrower $2 after a year of using the $100 loan, which is a lot to wrap your head around.

While negative interest rates are a great incentive to borrow, it’s hard to understand why anyone would be willing to pay to lend considering the lender is the one taking the risk of a loan default. While seemingly inconceivable, there may be times when central banks run out of policy options to stimulate the economy and turn to the desperate measure of negative interest rates.

Negative Interest Rates in Theory and Practice

Negative interest rates are an unconventional monetary policy tool and, until 2014, had never been implemented by a major central bank. The European Central Bank (ECB) became the first when its deposit rate declined to 0.2 percent in September, 2014. A number of other European nations turned to negative interest rates so that over one quarter of Eurozone government-issued debt had negative yields by the end of March 2015.

Negative interest rates are a drastic measure that show policymakers are afraid that Europe is at risk of falling into a deflationary spiral. In harsh economic times, people and businesses have a tendency to hold on to their cash while they wait for the economy to pick up. But this behavior can serve to weaken the economy further as the lack of spending causes further job losses and lower profits, thus reinforcing people’s fears and giving them even more incentive to hoard.

As spending slows, prices drop creating another incentive for people to wait as they wait for prices to fall further. This is precisely the deflationary spiral that European policymakers are trying to avoid with negative interest rates. By charging European banks to hold reserves at the central bank, they hope to encourage banks to lend more.

In theory, banks would rather lend money to borrowers and earn at least some kind of interest as opposed to being charged to hold their money at a central bank. Additionally, however, negative rates charged by a central bank may carry over to deposit accounts and loans, meaning that deposit holders would also be charged for parking their money at their local bank while some borrowers enjoy the privilege of actually earning money by taking out a loan.

Another primary reason the ECB has turned to negative interest rates is to lower the value of the euro. Low or negative yields on European debt will deter foreign investors, weakening demand for the euro. While this decreases the supply of financial capital, Europe’s problem isn’t supply but demand. A weaker euro should stimulate demand for exports, hopefully encouraging businesses to expand.

In theory, negative interest rates should help to stimulate economic activity and stave off inflation, but policymakers remain cautious because there are several ways such a policy could backfire. Because banks have certain assets like mortgages that, by contract, are tied to the interest rate, such negative rates could squeeze profit margins to the point where banks are actually willing to lend less.

Also, there’s nothing to stop deposit holders from withdrawing their money and stuffing the physical cash in mattresses. While the initial threat would be a run on banks, the drain of cash from the banking system could actually lead to a rise in interest rates – the exact opposite of what negative interest rates are supposed to achieve.

The Bottom Line

While negative interest rates may seem paradoxical, this apparent intuition hasn’t kept a number of European central banks from giving them a try. This is no doubt evidence of the dire situation that policymakers believe is characteristic of the European economy. When the Eurozone inflation rate dropped into deflationary territory at -0.6% in February 2015, European policymakers promised to do whatever it takes to avoid a deflationary spiral. But even as Europe embarked into unchartered monetary territory, a number of analysts believe negative interest rate policies could have severe unintended consequences.