What Are Negative Interest Rates?

In simplest terms, a negative interest rate means a borrower is credited interest instead of paying interest to the lender. In effect, the lender pays the borrower to take his money. You won’t typically see negative nominal interest rates in an ordinary market transaction. After all, why would anyone lend $1,000 to receive $900 in return at some point in the future? But central banks do sometimes use negative rates as an extreme monetary policy tool during deep recessions. 

Practically speaking, under a negative rate policy, financial institutions must pay to deposit excess reserves at the central bank. Normally, the central banks pay interest on funds deposited there. In effect, negative rates penalize banks for holding cash and incentivize them to lend cash out.  Negative rates are designed to stimulate more lending, borrowing spending and investment to help prop up the economy. Negative rates effectively penalizes banks, if they do not engage in sufficient lending.

More broadly, when negative interest rate policy is in play,  depositors are incentivized to spend money rather than save it at the bank and incur a guaranteed loss. In practice, commercial banks have been reluctant to pass negative rates on to their customers. Nevertheless, the negative rate central bank policy artificially depresses interest rates throughout the economy.The Federal Reserve has never dabbled in negative interest rate policy, but a number of other central banks have including the European Central Bank, Switzerland and the Bank of Japan.

Negative interest rates have a perverse effect on the economy. As Mises Institute president Jeff Deist wrote, “Negative interest rates turn everything we know about economics upside down.”

Negative interest rates are the price we pay for central banks. The destruction of capital, economic and otherwise, is contrary to every human impulse. Civilization requires accumulation and production; de-civilization happens when too many people in a society borrow, spend, and consume more than they produce. No society in human history previously entertained the idea of negative interest rates, so like central bankers we are all in uncharted territory now.”

Negative interest rates damage the structure of the economy destroy the free market in money and credit. They are a perverse contradiction to what true credit relationships should look like. The risk of parting with one’s capital for a duration of time should be appropriately compensated via the rate of interest. Having to pay a counterparty to loan out your capital with no compensation is an upside-down deal that no one would participate in if there weren’t better choices available.