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How Do Negative Interest Rates Work?

Negative interest rates are enacted during dire economic times and intended to boost spending and lending. Here's what you need to know when rates drop below 0.
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Negative interest rates occur infrequently and usually only when a country's central bankers are forced to utilize the monetary policy tool -- where the interest rates are set below zero -- during harsh economic times.

A negative interest rate means the lender is paying the individual or business to borrow money from them, which means that borrowers get paid and savers are penalized. This strategy stimulates borrowing and lending.

Negative Interest Rates Policy (NIRP)

The intent is to spur economic growth and increase inflation by incentivizing banks to give more loans, said K.C. Ma, director of the Roland George investments program at Stetson University in Deland, Fla. This results in businesses making investments and consumers spending more money.

During economic periods where low growth and falling prices occur, both people and businesses hoard money instead of spending and investing it.

"Left unchecked, this would result in a collapse of aggregate demand, further falling prices, a slowdown in real output, and an increase in unemployment," he said. "If stagnation is too deep, simply lowering the central bank's interest rate may not be sufficient to stimulate borrowing and lending."

Homeowners in Denmark are currently receiving checks each month because their mortgages have negative interest rates. This expansionary monetary policy was adopted back in the 1970s by the Swiss government.

Other countries have followed this strategy and Sweden utilized it in 2009 and 2010 while Denmark enacted it in 2012. The European Central Bank used it in 2014. In 2016, the Bank of Japan and the Bank of Israel announced a similar negative interest rate moves.

"Negative interest rates are the official policy of the European Central Bank with a deposit rate of -0.40%, Switzerland with -0.75%, Sweden with -0.35% and Bank of Japan with -0.10%," Ma said. "That is why all U.S. banks paid serious attention to Federal Reserve Chairwoman Janet Yellen's comment in February that she would not take negative interest rates off the table should the economy see a downward turn."

Negative Interest Rate Consequences

While getting a check back from your mortgage lender may seem too good to be true, there are many unintended consequences of negative interest rates. When banks are forced to pay a fee to keep their deposits with the central bank, they could opt to hoard the money instead of lending it out.

"There is some evidence to suggest that negative interest rates in Europe actually decrease the number of interbank loans," he said.

The same scenario could play out with retail banks who decide to absorb the costs associated with negative interest rates instead of passing the costs to consumers because they are fearful of bank runs.

"The expectation that bank customers and banks would move all their money holdings out for productive uses will not materialize," Ma said. "Imagine that banks impose negative interest rates on top of the fees you already pay on checking and savings account balances. It is just one more 'tax' on your money."

This strategy could also work as a "tax" on the banks and affect their profit margin and share prices.

The U.S. has been in a de facto negative interest rate environment for years such as when the Treasury Bill rate dropped below 1.5% for the past eight years, he said. The real interest rate has been negative, given an average of 1.5% to 2.0% inflation rate.

How Do Banks React to Negative Interest Rates?

"After various fees that banks already charge on your checking and money market accounts, do you really believe you are receiving that positive 0.25% interest rate?" he said.

Banks will not give out more loans because the cost of funds is lower. Both businesses and consumers will not borrow money and will look at the potential growth in the future so they can pay the loans back.

"Instead, they look at the likelihood of future growth so they can get their money back," Ma said. "Consumers will not take out loans to buy new cars or homes just because the financing term is attractive. The notion that negative interest rates will produce loans and generate economic growth is just wishful thinking."

The inflation-adjusted rate of interest or the "real" rate is the number that investors care about since it is the nominal rate adjusted for changes in purchasing power, said Mike Davis, an economics professor at the Cox School of Business at Southern Methodist University in Dallas. If individuals earn a rate of 5% but prices go up by 3%, they have only earned 2%.

The real rate can be negative in situations where inflation is unexpected. When real rates are negative, the economic situation is either already bad or likely to deteriorate, he said.

"The negative rates may by psychologically jarring, but there's nothing special about them. If rates change from 3% to 1%, they've fallen by 2%," Davis said. "If rates change from 1% to -1%, they've also fallen by 2%."