What is a negative interest rate environment?
A negative interest rate environment exists when the nominal overnight interest rate drops below zero percent for a particular economic area. This means that banks and other financial institutions would have to pay to keep their excess reserves stored at the central bank rather than receiving positive interest income.
A negative interest rate policy (NIRP) is an unconventional monetary policy tool by which nominal target interest rates are set with a negative value, below the theoretical lower limit of zero percent.
Key points to remember
- A negative interest rate environment exists when overnight lending rates fall below zero percent.
- In 2009 and 2020, Sweden and, in 2020, Denmark used negative interest rates to stem the flow of hot money into their economies.
- In 2020, the European Central Bank (ECB) instituted a negative interest rate that applied only to bank deposits intended to prevent the euro zone from sinking into a deflationary spiral.
- In a negative interest rate environment, financial institutions have to pay interest to deposit funds and can actually receive interest on borrowed money.
The basics of a negative interest rate environment
The impetus for a negative interest rate is to stimulate economic growth by encouraging banks to lend or invest excess reserves rather than suffer a guaranteed loss. The theory is that, with interest rates below zero, banks, businesses and households will stimulate the economy by spending money instead of saving it. A negative interest rate environment would encourage banks to make more loans, households to buy more products, and businesses to invest additional cash instead of depositing it in the bank.
Because it is logistically and costly to transfer and store large amounts of cash, some banks still accept negative interest on their deposits. However, if the interest rate is sufficiently negative, it will start to exceed storage costs. Negative interest rate environments aim to penalize banks for retaining cash instead of lending. They should, at least in theory, cause businesses and households to take out loans at lower cost, thereby encouraging more borrowing and injecting more liquidity into the economy.
Risks of a negative interest rate environment
There are certain risks associated with a negative interest rate environment. If banks penalize households for their savings, this will not necessarily encourage retail consumers to spend more money. Instead, they can raise money at home. The creation of a negative interest rate environment can even inspire a cash outflow, prompting households to withdraw their money from the bank in order to avoid paying negative interest rates for savings.
Banks wishing to avoid liquidity may refrain from applying the negative interest rate to the relatively small deposits of household savers. Instead, they apply negative interest rates to large balances held by pension funds, investment firms and other corporate clients. This encourages investors to invest in bonds and other vehicles that offer better returns while protecting the bank and the economy from the negative effects of liquidity.
Examples of negative interest rate environments
The Swiss government implemented a de facto negative interest rate regime in the early 1970s to counter the appreciation of its currency, as investors fled inflation in other parts of the world.
Recent examples of negative interest rate environments include the European Central Bank (ECB), which cut interest rates below zero in 2020. A year and a half later, in 2020, the Bank of Japan also adopted negative interest rates. Central banks in Sweden, Denmark and Switzerland also moved to negative interest rates between 2009 and 2020. These countries used negative interest rates to stem the flow of hot money into their economies in order to keep control of their exchange rates as foreign capital enters these economies.
Central banks have created negative interest rate environments in these countries to stop deflation, which they fear could quickly spiral out of control, devalue currencies, and derail economic progress since the Great Recession. However, negative interest rates have so far been low.
Central banks have been reluctant to lower negative interest rates too far below zero because the practice of creating negative interest rate environments only started recently, with the ECB being the first large financial institution to create such an environment. The ECB charges the banks with 0.4% interest to keep cash overnight. The Bank of Japan charges 0.10% interest to hold cash overnight, and the Swiss central bank charges 0.75% interest to hold cash.