Negative Interest Rates: Practical, But Limited

For a lot of people, the idea of negative interest rates sounds as if it must violate some law of nature, like a perpetual motion machine. Why would any depositor put money into an investment that promised a negative return? Well, starting way back in 2012, a substantial number of central banks around the world including the European Central Bank, the Swiss National Bank, the Bank of Japan, and the Sveriges Riksbank (the central bank of Sweden) have pushed the specific interest rates on which they focus monetary policy into negative territory for the last several years. Luís Brandão-Marques, Marco Casiraghi, Gaston Gelos, Güneş Kamber, and Roland Meeks offer an overview of the experience in "Negative Interest Rates: Taking Stock of the Experience So Far" (IMF Monetary and Capital Markets Department, 21-03, March 2021). 

Perhaps the obvious questions about a negative interest rate is why depositors would put money in the bank at all. The short answer is that banks provide an array of financial services to both businesses and individual customers (ease of electronic payments, not needing to hold large amounts of cash, access to credit, and so on). As a customer, you can pay for those services with some combination of fees and lower interest rates. It's easy to imagine a situation where slightly negative interest rates are offset by changes in other fees or contractual arrangements. 

It's also worth remembering that the fact of a negative interest rate in real terms is not actually new at all. Many times in the past, people have experienced negative real interest rates on their bank deposits--that is, when the inflation rate is higher than the nominal interest rate, the real interest rate is negative. 

Of course, if the bank interest rates became too negative, then depositors would indeed move away from banks and toward cash or other alternative investments. What is the "effective lower bound" for a negative interest rate? The answer will depend on various assumptions about the financial system, including costs of setting up companies that store large amounts of cash, but here's a set of estimates from various studies. 

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