Money & Finance

Negative interest rates explained

Last Updated on August 14, 2020

No one will blame you for thinking negative interest rates sound like fake news. Negative interest rates are a challenging concept to wrap your head around, but they are, in fact, a real thing. Before we dive into negative interest rates, let’s lay the groundwork for interest rates in general. Knowing why and how interest rates change will help you understand the whole concept behind a negative interest rate policy. 

Interest rates & the federal funds rate

The Federal Reserve is the central bank of the United States. Think of them as the bank for banks. The Federal Reserve sets what is called the federal funds rate. The federal funds rate serves as a benchmark for interest rates. The reason the Federal Reserve raises and lowers the federal funds rate to promote healthy levels of economic growth and to control inflation. 

Most of us think about interest rates in terms of how much we are charged for taking out a loan or what interest income we’ll receive on an account.

negative interest rates & the federal reserve

Now that we’ve got a baseline understanding of interest rates and how they work, let’s dig into the potential implications of a negative interest rate environment.

Negative interest rates explained

A negative interest rate policy (NIRP) is just that – the federal funds rate, and therefore interest rates, are set below zero. Let’s take a look at a very simple example to help paint the picture of what negative interest rates do. 

Traditional, positive interest rate environment

In this first part of the example, let’s assume the economy is in a ‘normal’, positive interest rate environment. You’d like to do some home improvement projects, so you go to the bank to take out a $1000 loan. Based on your good credit, you’re awarded a loan with a 2% annual interest rate. You pay off your loan in one year, which means that your $1000 loan cost you $20. Simply put, you ultimately paid $1020 to borrow $1000. 

Negative interest rate environment

Now let’s take a look at how the same loan would differ in a negative interest rate environment. You go to the same bank and ask for the same $1000 loan with the same great credit. In the context of negative interest rates, your bank would actually pay you to borrow money. If interest rates were -2% that means your loan of $1000 would cost you -$20. Ultimately, you would pay just $980 to receive your $1000 loan. Oddly, your bank would pay you to borrow their money. Sounds pretty good, right?

Why would interest rates go negative?

Remember earlier when we said that the Federal Reserve raises and lowers the federal funds rate to promote healthy levels of economic growth and to control inflation? This is why a central bank may consider pushing interest rates into negative territory.

Setting negative interest rates is considered a monetary policy of last resort. It is typically used when other efforts have not been successful at stimulating a damaged economy. As of May 2020, the United States has never implemented a negative interest rate policy, but other countries have, including Japan in 2016 and Switzerland in 2015. The graph below shows what the US federal funds rate has looked like over the last 50 years.

Effective Federal Funds rate over the last 50 years - interest rates have never been negative
Federal Reserve Bank of St. Louis

What does implementing a negative interest rate policy do?

Implementation of a negative interest rate encourages commercial banks to lend money to individuals and businesses. Recall that the Federal Reserve is the bank for banks. Rather than these commercial banks having to pay to keep cash reserves with the Federal Reserve, they are incentivized to lend money. Essentially, it would be cheaper for these commercial banks to lend money (even if they end up paying borrowers a little in interest) than to keep it on hand. 

Imposing negative interest rates is done in an effort to help jumpstart the economy. The idea is that if you can borrow more, you’ll spend more, helping to drive up consumer spending and therefore bolster the economy. Beyond consumer spending, the hope is that negative interest rates would incentivize businesses to borrow money and invest in things like technology, infrastructure, and the hiring of more staff. In theory, the combination of increased consumer spending and industry investment strengthen the economy as a whole.

Photo by Avery Evans on Unsplash

What are the drawbacks?

It would seem that negative interest rates would be all butterflies and rainbows then, right? Wrong. As just described, negative interest rates are typically good for borrowers (both businesses and individuals). But, they are bad for lenders and savers. 

History has shown that negative interest policies don’t work well. To start, commercial banks can be hesitant to pass along negative interest rates to their account holders for fear they’ll withdrawal their money. Additionally, a gloomy economic outlook doesn’t mean there will be more qualified borrowers for banks to lend to. Just because banks will be incentivized to lend money rather than stash it away doesn’t mean that lending money wouldn’t come with additional risk. Lastly, sustained negative interest rates tend to be detrimental to the value of the U.S Dollar, which comes with a whole host of other consequences. 

Essentially, history has shown a large disparity between the theory of instituting a negative interest policy and what has actually occurred in practice. In reality, neither Japan, or Switzerland has realized the benefits they were expecting.

What should you do?

The good news is that the US has never implemented a negative interest rate policy as of May 2020. The Federal Reserve has a number of monetary policy tools at its disposal in order to help bolster the economy. Fortunately, we are in the position to be able to study the results of other countries that have driven their economies into negative interest territory – and the data shows negative interest rates come with numerous downsides. 

The bottom line… No one can predict the future, but it’s important to remember that negative interest rates are seen as a monetary policy of last resort. Many banking and economic experts do not anticipate that the U.S will pursue negative interest rates. With that, the most practical course of action for us everyday consumers and investors is to keep making smart personal investment and purchasing decisions. Don’t get a loan for the sake of getting a loan, remember that it’s almost always best to stay the course in the market despite periods of volatility, stick to a smart budget, and make sure your emergency fund is healthy before making any big-money moves.

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