## How Can Interest Rates Be Negative?

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**Canonical URL:** [How Can Interest Rates Be Negative?](https://www.imf.org/-/media/files/publications/fandd/article/2020/march/what-are-negative-interest-rates-basics.pdf)

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### Historical and conceptual background
- Money has been used historically to compensate lenders; earliest institutionalized legal interest rate appears in the Laws of Eshnunna, an ancient Babylonian text dating back to about 2000 BC.
- Nominal interest rates are the stated rates borrowers pay on a loan; real interest rate = nominal rate minus rate of inflation.
- Example from the text: when inflation is 3 percent and the interest rate on a loan is 2 percent, the lender’s return after inflation is less than zero (real interest rate negative).
- Economic theories link interest rates to interactions between the supply of savings and demand for investment, and to the balance between money supply and demand.
- The policy interest rate set by a country’s central bank is the key benchmark for borrowing costs and influences mainly short-term interest rates.

### Recent developments and drivers of low/negative rates
- Several central banks have experimented with negative interest rates, including the European Central Bank and the central banks of Denmark, Japan, Sweden, and Switzerland.
- Motivation: to encourage banks to lend excess reserves rather than park them at the central bank, countering weak growth persisting after the 2008 global financial crisis.
- Long-term/neutral rate trends and drivers:
  - Broad agreement that the neutral interest rate has been on a clear downward trend for decades and is probably lower than previously assumed.
  - Possible drivers: long-term demographic trends (especially aging in advanced economies), weak productivity growth, shortage of safe assets.
  - Persistently low inflation in advanced economies, often significantly below targets or long-term averages, appears to have lowered markets’ long-term inflation expectations.
- Consequence: long-term interest rates have fallen and are now negative in many countries.

### Monetary policy mechanics and the zero lower bound
- After the global financial crisis, central banks cut nominal interest rates aggressively, in many cases to zero or close to zero — referred to as the zero lower bound.
- Negative interest rates operate through similar mechanics as positive rates: they give consumers and businesses an incentive to spend or invest rather than hold bank deposits that are eroded by inflation.
- A low neutral rate implies short-term interest rates could more frequently hit the zero lower bound and remain there for extended periods, increasing reliance on unconventional policies including negative policy interest rates.

### Risks, constraints, and banking-sector implications
- Bank profitability risk:
  - Banks earn a spread between what they pay depositors and what they charge on loans.
  - Lower policy rates tend to reduce this spread as lending and longer-term rates fall.
  - If banks do not pass negative rates on to depositors (for fear of deposit withdrawals), the lending spread could turn negative, lowering bank profitability and potentially undermining financial stability.
- Cash drain risk / effective lower bound:
  - Negative rates on deposits incentivize savers to switch to cash, since cash’s face value cannot be reduced.
  - There is uncertainty about where an effective lower bound lies; going below it could cause depositors to withdraw funds into cash, undermining financial system liquidity and stability.
  - Some proposals discussed (but not implemented in the source) include eliminating cash to enable deeply negative rates.
- Practical mitigation observed:
  - Banks can charge other fees to recoup costs.
  - Rates have not become so negative that banks attempt to pass negative rates to small depositors; larger depositors have accepted some negative rates for convenience.

### Implications and policy considerations
- Negative policy interest rates are a tool central banks may increasingly need to use when neutral rates are low and conventional policy is constrained by the zero lower bound.
- Policymakers must weigh potential benefits in stimulating spending and investment against risks to bank profitability, financial stability, and the possibility of cash-driven deposit flights.
- The existence of cash as an alternative limits how negative policy interest rates can be in practice.

*VIKRAM HAKSAR is an assistant director and EMANUEL A. KOPP a senior economist in the IMF’s Strategy, Policy, and Review Department.*

*Source: what-are-negative-interest-rates-basics (PDF).*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2020/march/what-are-negative-interest-rates-basics.pdf_