Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Negative Interest Rates
Transcript
- Lucas: So in June 2014, the European Central Bank did something that most economists had considered unthinkable just a few years earlier – it pushed its deposit rate below zero. Minus 0.1 percent. And over the next five years, it kept digging deeper, all the way down to minus 0.5 percent. Luna: And that means banks actually had to pay to park their excess reserves at the ECB. The opposite of earning interest. Lucas: Exactly. The logic was straightforward: if you penalize banks for hoarding cash, they‘ll lend it out instead, stimulating the economy. But the real story is a lot messier than that textbook explanation. Because negative rates don’t just hit banks – they ripple through the entire financial system in ways central banks didn‘t fully anticipate. Luna: Like the impact on bank profits. I remember reading that European bank stocks actually underperformed during the negative rate years. Lucas: They did, and that’s one of the major unintended consequences. See, banks make money from the spread between what they pay on deposits and what they earn on loans. Normally, that spread is fairly stable. But when the policy rate goes negative, banks are reluctant to pass that negative rate on to retail depositors – because they know customers will just pull their money out. So banks absorb the cost themselves, and their net interest margin gets crushed. Luna: And that margin compression is exactly what we saw across Europe. A 2019 study from the Bank for International Settlements estimated that negative rates reduced European bank profits by about 20 percent over five years. Lucas: Right, the BIS study was a wake-up call. And it raises a fundamental question: if negative rates hurt the very institutions that are supposed to transmit the policy to the real economy, do they actually stimulate lending? The evidence is mixed. On one hand, credit did expand in the eurozone after 2014. On the other hand, the banks that were most exposed to negative rates – the ones with high deposit bases – actually tightened lending standards more than banks with less deposit reliance. Luna: So the policy may have backfired for some banks. But the ECB had another goal: weakening the euro to boost exports. And on that front, negative rates did seem to work, at least initially. Lucas: That‘s a good point. The euro did weaken from around $1.39 in early 2014 to below $1.05 by early 2017. But by then, the trade-weighted impact was harder to isolate because the ECB was also doing quantitative easing. So negative rates were part of a package, not a silver bullet. Luna: And of course, there’s the savings channel. Policymakers hoped that negative rates would push households to spend rather than save. But in practice, many European households actually increased their saving rates during this period – the opposite of what the ECB wanted. Lucas: That‘s the so-called 'reversal rate' problem – a concept introduced by Princeton economist Markus Brunnermeier and others. The idea is that at some negative threshold, the policy stops stimulating and actually becomes contractionary. Because banks, hurt by low margins, cut lending. And households, worried about low returns, save more to meet their retirement goals. It’s a really counterintuitive dynamic. Luna: And the ECB itself acknowledged this in 2019 when it introduced a tiered deposit rate – exempting part of banks‘ reserves from the negative rate. That was an implicit admission that the policy had costs. Lucas: Yeah, the tiering was a big deal. It meant that only a portion of excess reserves were charged the negative rate, which effectively raised the average rate banks earned. That helped cushion bank profits. But it also diluted the policy’s transmission, because the marginal incentive to lend was reduced. Luna: So what‘s the verdict? Did negative rates work in Europe? Lucas: I think the honest answer is: they prevented worse outcomes, but they didn’t deliver a strong recovery. Inflation stayed persistently below the ECB’s target of near 2 percent for most of the period. And once the pandemic hit, the ECB actually cut rates further to minus 0.5 percent – the floor. So the policy had become a permanent fixture, not a temporary tool. Luna: And then in 2022, when inflation surged, the ECB started raising rates back above zero. So the negative rate experiment effectively ended after about eight years. What did we learn? Lucas: I think the biggest lesson is that the zero lower bound isn‘t really zero – it’s somewhere above zero, because of the damage to bank intermediation. Central bankers now talk about the 'effective lower bound' rather than zero. And that‘s changed how they think about policy tools going forward. Luna: There’s also the lesson about communication. The ECB‘s negative rate policy was highly controversial in Germany, where there’s a deep cultural aversion to anything that penalizes saving. That political pushback constrained how aggressively the ECB could use the tool. Lucas: And that’s a really important point – monetary policy doesn‘t operate in a vacuum. The same negative rate that might be acceptable in Japan or Switzerland can be politically toxic in Germany. So the tool’s effectiveness depends on the institutional and cultural context. Luna: Speaking of cultural context – you know, it‘s funny, when we talk about these complex policy trade-offs, it reminds me that it’s only because listeners like you support this show that we can spend time drilling into something like the reversal rate or tiered reserve systems. We don‘t have ads, we don’t have sponsors pushing a narrative. It‘s just the economics. And a handful of people who chip in monthly through Buy Me a Coffee make that possible. Lucas: Yeah, it’s a small group, but it makes a real difference. If walking through the economy with us has made something click, Buy Me a Coffee dot com slash fexingo is where you can join them. No pressure, no perks – just the satisfaction of keeping this ad‑free. And we mean it when we say thank you. Luna: Exactly. So back to the policy – one more angle I think is worth exploring: could negative rates ever come back? With inflation still above target in mid‑2026, it seems unlikely. But if the next downturn hits while rates are still near zero, central banks might have to reconsider. Lucas: That’s the billion‑dollar question. The Bank of Japan actually kept negative rates until early 2026 – they only just exited. And some economists argue that the next recession will force central banks to go even deeper negative, perhaps with safeguards like tiering or even digital currency that allows rates to be passed directly to consumers. Luna: Right, because if you had a central bank digital currency, you could impose negative rates on it directly – no bank intermediation needed. That changes the calculus. Lucas: It does. But it also raises huge privacy and political questions. So for now, negative rates remain a tool that central banks are glad to have in the drawer, but one they hope they won‘t have to use again. The lesson from Europe is that negative rates are like a strong antibiotic: they can fight an infection, but they come with side effects that require careful management. Luna: And sometimes the cure is worse than the disease. But we’ll keep watching – and bring you the numbers as they come.