Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Set Negative Interest Rates
Transcript
- Lucas: Luna, imagine a world where you lend someone a hundred dollars, and they pay you back ninety-eight. That's essentially what negative interest rates mean for banks that park money at the central bank. Luna: That sounds punishing. Why would any central bank do that? Lucas: Because they want to push banks to lend instead of hoarding reserves. The classic case is the European Central Bank, which first took its deposit facility rate below zero in June 2014. At its deepest, in September 2019, the rate hit negative 0.5 percent. Luna: So banks had to pay the ECB half a percent on every euro they left on deposit overnight. That's not a small cost. Lucas: Right. The idea was straightforward: if parking reserves is expensive, banks will look for higher-yielding alternatives, namely lending to businesses and households. The ECB wanted to stimulate credit creation and, ultimately, inflation, which was stubbornly below its target of close to 2 percent. Luna: But there was pushback. European banks complained that negative rates squeezed their net interest margins—the spread between what they earn on loans and what they pay on deposits. Lucas: Exactly. Banks were reluctant to pass negative rates on to retail depositors—charging Grandma for keeping her savings in a checking account is politically toxic. So they absorbed the cost themselves, which ate into profitability. The ECB eventually introduced a tiering system in 2019, exempting a portion of banks' excess reserves from the negative rate. Luna: How big was that exemption? Did it actually help? Lucas: Under the tiering system, banks could hold up to six times their minimum reserve requirements at zero percent instead of negative 0.5 percent. For most banks, that covered all or most of their excess reserves. So the effective rate they paid was much closer to zero. It was a classic compromise: keep the policy rate negative to signal accommodative intent, but soften the blow on the banking sector. Luna: And did negative rates actually work? Did they boost lending and inflation? Lucas: The evidence is mixed. On lending, there's research showing that negative rates did increase bank lending in the Eurozone, especially for banks with more retail deposits. But the effect was smaller than conventional rate cuts. On inflation, the ECB never consistently hit its 2 percent target during the negative-rate era—inflation averaged around 1.2 percent from 2014 to 2019. Luna: So it wasn't a silver bullet. But other central banks also went negative—the Bank of Japan, the Swiss National Bank, the Riksbank. Lucas: The Swiss National Bank actually had the deepest negative rate among major economies, setting its policy rate at negative 0.75 percent for several years. Their motivation was partly to weaken the Swiss franc, which was surging as a safe haven. Negative rates made holding franc-denominated assets less attractive. Luna: And Japan? Lucas: The Bank of Japan introduced a negative rate of negative 0.1 percent in January 2016, but it applied only to a portion of banks' reserves—a tiered system right from the start. The impact on lending and inflation was modest at best. Japan has been fighting deflation for decades; negative rates alone weren't enough. Luna: One central bank that never went negative was the Federal Reserve. Why is that? Lucas: Several reasons. First, the Fed's policy rate never fell to the effective lower bound in 2020 because it cut to zero to 0.25 percent and then used forward guidance and quantitative easing as additional tools. Second, there was strong political and industry opposition. Many economists worried that negative rates would disrupt the money market mutual fund industry, which had already broken the buck in 2008. Luna: And there was a legal question: the Federal Reserve Act doesn't explicitly authorize negative interest on reserves. Lucas: That's right. The Fed's then-chair, Jerome Powell, repeatedly said negative rates were not an appropriate tool for the U.S. economy. But some economists argue that if the next recession hits while rates are still near zero, the Fed might have to reconsider. Luna: Speaking of next recessions, one thing we try to do on this show is give people a clearer lens on how the economy really works. If walking through the economy with us has made something click, we hope you consider supporting the show. A couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo. Lucas: Yeah, it's listener-supported, ad-free, and the only reason we can dive into things like negative rate tiering without sponsors. Back to the topic: what are the known side effects of negative rates that make them so controversial? Luna: Beyond bank profitability, there's the impact on pensions and insurance companies. They promise fixed returns, and negative rates make it nearly impossible to earn those returns without taking on more risk. Lucas: Exactly. In Germany, for example, life insurers had to increase reserves because the low-rate environment depressed their investment income. Some even stopped selling products with guaranteed returns. That has real consequences for retirees. Luna: Then there's the behavioral effect: if people feel punished for saving, do they actually spend more? Or do they just save more to compensate for lower returns? Lucas: That's the big open question. Some studies from Japan and the Eurozone suggest that households actually increased their saving rates during negative-rate periods, the opposite of what policymakers wanted. It's possible that the traditional transmission mechanism breaks down at very low or negative rates. Luna: So is the era of negative rates over? The ECB raised rates out of negative territory in 2022, and so did the Riksbank and the Bank of Japan only ended its negative rate policy in early 2024. Lucas: For now, yes. But the structural forces that drove rates lower over the past two decades—aging populations, low productivity growth, high savings demand—haven't disappeared. If inflation stabilizes and the next downturn arrives, central banks may once again face the zero lower bound. The question is whether they will return to negative rates or rely more on other tools like quantitative easing and forward guidance. Luna: I think the reputation of negative rates has been tarnished. The costs were more visible than the benefits, and political blowback was intense. Lucas: Agreed. The ECB's own strategic review in 2021 acknowledged that negative rates had side effects on bank profitability and that the policy was less effective when rates were deeply negative. They might still be used in a future crisis, but probably with more safeguards—like the tiering systems we saw. Luna: And perhaps with a clearer plan for how to protect the banking sector and pension funds from the start. Lucas: Right. Because the key lesson from the past decade isn't that negative rates are impossible—it's that they need to be designed carefully. The ECB's tiering was a patch, not a solution. The next time around, central banks might pair negative rates with direct support for banks or even fiscal policy coordination. Luna: Or they might decide the costs outweigh the benefits and instead rely on larger quantitative easing programs. That's essentially what the Fed chose. Lucas: Exactly. So we're left with a toolbox that includes negative rates, but it's a tool central banks will be very hesitant to use. It's not off the table—but it has a much higher threshold now. Luna: One concrete number I'll remember: banks paying half a percent to deposit reserves—that's a powerful incentive to lend, but also a powerful incentive to complain. Lucas: And that tension between incentive and complaint defines the whole negative-rate debate. Thanks for listening—next time, we'll look at another unconventional tool: yield curve control.