Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Go Negative with Interest Rates
Transcript
- Lucas: When we think about central bank policy tools, negative interest rates are probably the most counterintuitive. I mean, charging banks to park reserves at the central bank — it sounds almost like a penalty, which of course it is. Luna: And yet several major central banks have used it. The European Central Bank went negative in 2014. Their deposit facility rate dropped below zero for the first time. Lucas: Exactly. The ECB's deposit rate went to minus 0.1 percent in June 2014, and eventually all the way down to minus 0.5 percent by 2019. That was a deliberate effort to push banks to lend rather than sit on reserves. Luna: But doesn't it hurt bank profitability? I mean, if banks are losing money on reserves, they might just pass the cost on to customers or take on more risk to compensate. Lucas: That's the big trade-off. In theory, the lower the deposit rate goes, the more incentive banks have to lend because holding reserves costs them. But in practice, banks face what's called the 'reversal rate' — the point at which negative rates actually reduce bank profitability and reduce lending. Luna: So how did the ECB manage that? They used a tiered system, right? Lucas: Yes. In 2019, the ECB introduced a two-tier system for reserve remuneration. Banks were allowed to exempt a certain multiple of their required reserves from the negative rate. Only excess reserves above that threshold were charged. That was meant to protect bank margins while still providing the incentive to lend. Luna: And the Bank of Japan also went negative in 2016. They used a three-tier system, I recall. Lucas: Correct. The Bank of Japan applied a negative rate of minus 0.1 percent only to a portion of reserves called the 'policy-rate balance.' Their tiering was even more protective. The aim was to weaken the currency and fight deflation, but the impact on lending was modest at best. Luna: So did negative rates actually work? Did they boost lending and inflation? Lucas: The evidence is mixed. A 2021 study by the Bank for International Settlements found that negative rates in the euro area did lead to lower bank lending rates and some increase in credit volumes, especially for loans to non-financial corporations. But the effect on inflation was more difficult to isolate. Luna: And there were side effects. Banks complained about margin compression, and there was a lot of talk about people hoarding cash to avoid negative deposit fees. Lucas: Right. Cash hoarding became a real concern. In theory, if retail deposit rates go negative, people could just pull their money out of the bank and hold physical cash. That creates a lower bound on how far negative policy rates can go — the so-called 'effective lower bound.' Luna: Did any central bank actually reach that bound? Lucas: The ECB never went below minus 0.5 percent, and the Bank of Japan stuck at minus 0.1. The Swiss National Bank went as low as minus 0.75 percent for a while, but they didn't see a massive shift to cash, partly because Swiss banks charged institutional depositors but largely spared retail customers. Luna: So negative rates were a tool for very specific deflationary environments. But now most central banks are in a tightening cycle. The ECB raised rates above zero in 2022 and stayed positive. Lucas: Yes. As of July 2026, the ECB's deposit rate is at 3.25 percent after several cuts from the peak. So negative rates are currently a historical footnote in Europe. But the tool still exists in the toolkit. Luna: Could they come back? If we had another severe recession or deflation shock? Lucas: Possibly. Central banks have learned how to soften the side effects through tiering, so the cost to banks is lower. But the political backlash and the lingering impact on bank business models make it a less attractive option than, say, quantitative easing or forward guidance. Luna: And there's also the issue of the neutral rate. If r-star — the neutral real rate — has risen, then negative nominal rates might not even be needed to be stimulative. Lucas: Exactly. That was one of the lessons of the post-2008 period: the neutral rate was likely very low, so negative rates made sense. But if neutral rates have moved up due to factors like fiscal expansion or productivity growth, the threshold for going negative is higher. Luna: So what's the key takeaway for someone trying to understand how central banks operate? Lucas: That negative interest rates are a sign that a central bank is willing to push beyond conventional boundaries to meet its inflation target. They reveal the depth of the zero lower bound problem. And they forced economists to think about the limits of monetary policy in a way that we hadn't before. Luna: You know, it's funny — when this show explains concepts like tiering or the effective lower bound, it makes the whole system feel more comprehensible. It's one of those economic ideas that once you get it, the rest clicks. Lucas: That's exactly the kind of reaction we hope for. And if walking through the economy with us has made something click for you, there's a simple way to support the show and keep it ad-free. It's like a small contribution at buy me a coffee dot com slash fexingo. Luna: Yeah, it genuinely helps. Every bit goes toward research and keeping the conversation going. So thanks to anyone who's ever chipped in. Lucas: Alright, back to the topic. So the future of negative rates? I think they're not dead, but they will only be used if deflation risks are acute and other tools are exhausted. The experience of the 2010s gave central banks a roadmap for how to deploy them with fewer side effects. Luna: And now, with the recent rate cuts we've seen from several central banks in 2026, the question is more about where the neutral rate lies and whether we have room to cut without going below zero. Lucas: Right. The debate about the neutral rate is ongoing. But one thing is clear: the taboo around negative rates is gone. Policymakers know it's an option, even if they hope they never have to use it again.