How would negative interest rates work?
During her Feb. 11 testimony before a U.S. Senate committee, Federal Reserve Chair Janet Yellen was asked whether the Fed had considered imposing negative interest rates on banks. She made it clear that the Fed does not plan to implement negative interest rates absent a severe deterioration in economic conditions. But five other central banks around the globe—in Japan, Sweden, Switzerland, Denmark, and the Eurozone—have already done so in attempts to boost their respective economies. In effect, negative rates provide an incentive to banks to increase lending.
Negative interest rates were unheard of only a few years ago, and most people are unfamiliar with them. Here we explain how, in theory, this policy would work, should the Fed impose it.
The U.S. central bank controls two interest rates that are important to banks. One is the interest on excess reserves, which the Fed pays to banks on money they deposit with it. The Fed sets this rate, currently at 0.5 percent. The other is the federal funds rate, which the Fed influences by offering funds on the interbank market, where banks borrow from one another. The Fed raised its target for this rate to 0.25 percent to 0.5 percent on Dec. 16, 2015, the first increase since mid-2006.
If the Fed were to decide that the U.S. economy needs a significant boost, it could set both of these rates below zero to spur lending. With negative interest on excess reserves, banks would have to pay the Fed to hold their funds. This should give them an incentive to loan the money rather than keep it at the Fed. The increased lending would boost economic activity.
The potential to increase lending is significant, because large bank reserves have been accumulating since the financial crisis in 2008 and are currently over $2.4 trillion (Chart 4). However, it is not clear how effective lending some of the cash would be in boosting economic activity. Interest rates are already quite low, so borrowing is fairly cheap for businesses and individuals. Interest rates paid by high-quality borrowers (both businesses and individuals) hover around 4 percent to 5 percent, close to all-time lows (Chart 5). It is unlikely that a further decline in these rates would boost this type of borrowing much.
But the picture is different in higher-risk lending. Interest rates on riskier, high-yield bonds have been rising since late 2015. If banks increased their lending significantly to avoid paying fees on excess reserves, they may venture into riskier loans by lending to lower quality borrowers. This might boost economic activity for a time, but it would also expose banks to potential dangers. Taking on higher risks may not be a good idea for banks, as the last financial crisis showed.
If the Fed sets negative interest rates for banks, will those institutions in turn impose a fee on depositors instead of paying interest? Not likely. Savers typically have options other than keeping their money in a bank. The interest that banks pay on deposits likely would narrow but not fall below zero. This would not be much of a change from the current situation, where interest rates that savers earn are already close to zero.