Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Negative Interest Rates Actually Work
Transcript
- Lucas: So, negative interest rates. We've all heard the phrase, but what does it actually mean for a central bank to set a negative rate? The European Central Bank did it in 2014, the Bank of Japan in 2016, and a bunch of other central banks have experimented with it. Let's get past the headline and into the mechanics. Luna: Yeah, because the phrase itself sounds like a paradox. You're supposed to earn interest on your savings, not pay the bank to hold your money. Lucas: Right. And that's actually the key friction point. So the first thing to understand is what rate we're talking about. Usually, it's the rate on central bank reserves. Commercial banks have to hold reserves at the central bank — think of it like a checking account. Normally, the central bank pays them interest on those reserves. Under negative rates, the central bank charges them. The idea is to push banks to lend instead of parking money at the central bank. Luna: So the central bank is essentially saying, 'We're going to tax your idle cash, so go out and make loans.' Lucas: Exactly. The European Central Bank set its deposit facility rate to negative 0.1 percent in June 2014. By 2019, it was at negative 0.5 percent. And the hope was that this would trickle down—lower lending rates for businesses and households, stimulate spending, fight deflation. Luna: Did it work? I mean, we've got almost a decade of data now. Lucas: The evidence is mixed. On lending volumes, especially in the euro area, we did see some increase in bank lending after the policy was introduced. But the transmission was uneven. In Denmark, some mortgage rates actually went negative — homeowners were effectively getting paid to borrow. That sounds great, but it also created distortions. Luna: Distortions like what? I remember hearing about money market funds breaking the buck because they couldn't generate returns. Lucas: That's a big one. Money market funds rely on short-term yields, and when rates go negative, their business model collapses. In Europe, many funds either closed or started charging fees to hold cash, which defeated the purpose. Also, banks found it hard to pass negative rates to retail depositors. They worried that if they charged regular savers, people would just pull their cash out and stuff it under the mattress. Luna: And if everyone does that, you get a bank run. So there's a limit to how negative you can go. Lucas: Precisely. That limit is sometimes called the 'effective lower bound' — below which the costs of holding cash become less than the cost of negative rates. But there's another theory called the 'reversal rate,' which says that beyond a certain point, negative rates actually reduce bank lending because they squeeze bank profitability too much. If banks are losing money on reserves, and they can't pass it on to depositors, their net interest margin shrinks. They may then tighten lending, not expand it. Luna: So the ECB was aware of this. They introduced a tiered system in 2019, right? Exempting a portion of reserves from the negative rate. Lucas: Yes. They created a two-tier system where a multiple of a bank's required reserves was exempted from the negative rate. Only excess reserves above that threshold were charged. That protected bank profitability to some extent. The Bank of Japan also had a tiered system from the start — they applied a negative rate only to a portion of reserves, not all of them. Luna: It's interesting that the Fed never went negative. Even during the pandemic, they cut rates to near zero but not below. Why was that? Lucas: Several reasons. One, the US economy is less reliant on bank lending than Europe or Japan — more capital markets financing. Two, the money market fund industry in the US is enormous, and the Fed was worried about the same kind of disruption. And three, there's a political dimension. The public really dislikes the idea of negative rates. It feels like a punishment for saving. Luna: It does feel like a punishment. But I think people misunderstand it — it's not that your checking account goes negative. It's the rate at the wholesale level. Lucas: Right. For most people, the impact is indirect. You might see lower mortgage rates, but you might also see lower savings account yields. But there was actually a case in Switzerland where some banks did start charging large depositors. And a few Danish banks briefly offered negative mortgage rates — so your loan balance would actually shrink over time if you made payments. But that was the exception. Luna: Let's talk about the evidence from Japan. They've been at negative rates since 2016. Has it helped inflation? Lucas: Not really. Japan's inflation stayed stubbornly low. The Bank of Japan's negative rate was only on a small portion of reserves, so the actual policy signal was weak. And they've had deflationary pressures for decades. Negative rates alone didn't fix that. In fact, the Bank of Japan ended its negative rate policy earlier this year, in March 2026, raising rates back to zero. Luna: So they abandoned it. Does that mean the experiment failed? Lucas: I'd say it's more nuanced. Negative rates probably prevented worse outcomes — they kept borrowing costs low, supported asset prices, and maybe prevented deflation from deepening. But they didn't generate strong growth or inflation. And they came with side effects: compressed bank margins, strained money market funds, and potential risks to financial stability if banks take on too much risk to chase yield. Luna: It's interesting that walking through the economy with us has made something click — at least, I hope it has for our listeners. We deliberately don't run ads on these shows, and that's a choice we make to keep the focus on the substance. If you find that valuable and want to support it, the link is buy me a coffee dot com slash fexingo. No pressure, just if it makes sense. Lucas: Yeah, absolutely. It's a way for listeners who get real value from the show to keep it going ad-free. And we appreciate it. So back to negative rates — one more angle I want to hit. What happens when a central bank wants to raise rates out of negative territory? That's what the ECB started doing in 2022. They raised rates aggressively, but they had to unwind the tiering system carefully. Luna: Because banks had gotten used to the exemption. Raising rates too fast could have hurt them. Lucas: Exactly. The ECB raised its deposit rate from negative 0.5 percent all the way to 4 percent by late 2023. That was a huge move. And they had to adjust the tiering multiple so that banks weren't suddenly hit with a massive cost. In the end, they eliminated the exemption once rates were positive again. So the exit was messy but manageable. Luna: What about the rest of the world? Are we likely to see negative rates again? Lucas: It's possible if a deep recession hits and rates are already near zero. But I think central banks are more cautious now. They know the side effects. Some economists argue for 'helicopter money' or other fiscal-monetary coordination as alternatives. But if deflation becomes severe, negative rates will be on the table again. The Bank of Japan's exit doesn't mean the tool is dead — it just means it's not a silver bullet. Luna: So the takeaway is: negative rates are a bit like a strong medicine. It can work in a crisis, but it's not something you want to take long-term. Lucas: That's a good way to put it. And the evidence from the last decade gives us a much clearer picture of the costs and benefits. The next time a central bank faces the zero lower bound, they'll have a lot more data to decide whether to go negative or try something else. Luna: And hopefully, by then, the public will understand it better too. Lucas: That's the goal. For now, that's what we've got on negative interest rates. Thanks for listening.