Skip to main content

Negative interest rates explained: how and why they work

In 2014, the European Central Bank did something that violated basic economic intuition: it set a negative interest rate. Banks were charged a fee—not paid interest—for holding money at the central bank. Sweden, Denmark, Switzerland, and Japan followed suit. The idea seemed backwards: who would charge for a loan?

Yet negative interest rates are a logical extension of monetary policy at the zero lower bound. When positive rates and quantitative easing fail to stimulate a depressed economy, central banks push deeper into negative territory. The logic is simple: by making deposits at the central bank more costly than lending out, the central bank incentivizes banks to pass the cost along through lending rather than hoarding reserves. By making savings less attractive (negative returns), central banks hope to push households and firms toward spending and investment.

Negative interest rates are a desperate policy tool, born out of deflation and stagnation. They carry large costs and unintended consequences: bank profitability suffers, savers are penalized, capital flight to other countries accelerates, and financial stability risks increase. Yet when traditional tools exhaust themselves and the economy remains trapped in low inflation or deflation, negative rates become tempting.

Quick definition: Negative interest rates occur when a central bank sets its policy rate below zero, charging banks a fee for holding deposits rather than paying them interest, with the goal of incentivizing lending and discouraging saving in a depressed economy.

Key takeaways​

  • Negative interest rates push the policy rate below the zero lower bound by penalizing cash holdings and reserve accumulation.
  • The mechanism targets the effective lower bound (the floor below which people prefer cash) rather than the nominal zero bound.
  • Negative rates are designed to encourage banks to lend and households to spend, both by raising the cost of saving and by signaling desperation and long-term weak growth.
  • Central banks that have used negative rates—the ECB, Bank of Japan, Swiss National Bank, Riksbank of Sweden—have found effects modest and side effects substantial.
  • Negative rates impose significant costs on banks through compressed profit margins, punish savers, create distortions in asset markets, and risk capital flight.
  • The public and political tolerance for negative rates is limited, constraining how far below zero central banks can push.

The mechanics: how negative rates actually work​

A central bank sets a negative policy rate by announcing that banks will be charged an interest rate on reserves held at the central bank. For example, the ECB in 2019 set its deposit facility rate at –0.5%, meaning banks paid €50,000 per year to hold €10 million in reserves at the ECB.

What is the goal? The goal is to make holding reserves unprofitable, forcing banks to either lend the money out (and thus stimulate lending) or move the reserves elsewhere (spurring competition for deposits and lower lending rates). The central bank is trying to push the system further from the zero lower bound's constraint.

How does it move interest rates? When banks are charged to hold reserves, they reduce the interest paid on deposits (to compensate for the cost of negative rates) or raise the rate they charge on loans. The intent is twofold: (1) lower lending rates on mortgages, auto loans, and business loans should stimulate borrowing; and (2) lower deposit rates should discourage saving and encourage consumption and investment.

The cash backstop: Why can't rates go deeply negative? Because for every euro held at the central bank at –0.5%, a bank can instead hold one euro of physical cash (earning 0%). If rates fall to –2%, the cost of holding negative-rate deposits far exceeds the benefit, so banks withdraw cash. This limits how far negative the central bank can push without triggering massive cash withdrawal. The point at which people prefer cash to deposits is called the effective lower bound, and it typically lies somewhere between –0.5% and –1%.

Why do central banks turn to negative rates?​

Negative rates emerge only when all other tools are exhausted and the economy remains depressed. They are a policy of last resort, deployed only when both standard rate cuts and quantitative easing have failed to restore growth.

The deflation problem: Negative rates are most likely when the central bank faces persistent low inflation or deflation. In deflation, the real interest rate (the nominal rate minus the inflation rate) is high even if nominal rates are zero. If inflation is –1% and rates are 0%, the real rate is 1%, which is contractionary. Lowering nominal rates below zero (to –0.5%) brings the real rate down to 0.5%, in theory more accommodative.

Numeric example: Japan in the 2010s provides the motivation for negative rates. Japanese inflation had been stuck at or below zero for 15 years. The Bank of Japan had held rates at zero since 1999 and pursued QE since 2001. Yet inflation remained at 0%, unemployment was around 2.5% (low), but growth was stagnant at 0.5–1% per year. The BOJ adopted negative rates in January 2016, setting the policy rate at –0.1%, hoping to break expectations of persistent low inflation. The policy had modest effects—inflation only reached the BOJ's 2% target temporarily and fell back.

Stagnation without deflation: Negative rates can also be deployed in economies with low (but positive) inflation and stagnant growth. The eurozone in 2014–2015 had inflation below the ECB's 2% target and tepid growth of 1–1.5%. Unemployment was still above 10%. The ECB adopted negative rates not because of outright deflation but because other tools had failed and desperation for stimulus was high.

How negative rates are supposed to work: the channels​

The theoretical transmission channels for negative rates are similar to those for positive rate cuts, but with added complications.

The interest rate channel: Banks facing negative rates on reserves should lower lending rates to compensate. A mortgage rate of 3.5% should fall to 3.0% or lower. This should encourage borrowing for homes and business investment. However, this channel is weak because banks fear that passing on negative rates to customers will cause deposit flight. Banks often absorb the negative rate cost rather than lower lending rates substantially.

The exchange rate channel: Negative rates make a country's currency less attractive (lower returns), weakening the currency and making exports more competitive. For the ECB, a weaker euro helped German exporters and boosted eurozone competitiveness. But this channel also invites retaliation—other countries adopt negative rates in response, nullifying the relative advantage.

The asset price channel: Negative rates make money market funds and savings accounts worthless, pushing savers toward stocks, bonds, and real estate to find any yield. Asset prices should rise, boosting wealth and consumption. This channel has been powerful in practice: the ECB's negative rates coincided with a rally in European stock markets and real estate from 2016 onward.

The expectations channel: Negative rates signal desperation—the central bank believes the economy is so weak that it must charge for saving. This may anchor inflation expectations and convince firms and households that the central bank will keep rates low for years, encouraging current spending. Alternatively, it may depress animal spirits and convince them the situation is dire (making them more pessimistic).

The credit channel: Negative rates should incentivize banks to lend rather than hoard. But in practice, banks don't lend aggressively just because rates are negative; they lack profitable lending opportunities. The problem in depressed economies is not the cost of capital but the absence of borrowers willing to borrow.

The reality: modest effects, large side effects​

The evidence from negative-rate experiences suggests that effects on real lending and growth have been modest while side effects have been substantial.

The ECB's experience: The ECB set negative rates in 2014 (–0.1%) and deepened them to –0.5% by 2019. Eurozone lending growth did accelerate from 2014 to 2016, but growth remained tepid at 1–2% per year. Was the acceleration due to negative rates or to improving credit conditions post-crisis? The counterfactual is hard to assess. Inflation, the stated target, remained stubbornly below 2%, suggesting the negative rates were insufficient to hit the goal. Meanwhile, banks complained about compressed profit margins (they earn negative returns on reserves but cannot push deposit rates much more negative without deposit flight).

Japan's negative rate experience: The BOJ adopted –0.1% in January 2016. Bank lending growth did increase, but the economy remained weak, with inflation rising to 1% temporarily but falling back. The BOJ deepened rates to –0.2% by September 2016. By 2018, facing political pressure and evidence that negative rates were not delivering the promised inflation, the BOJ paused further cuts and eventually began considering rate increases. The experience suggested negative rates alone, without fiscal support, were insufficient to break Japan's deflationary trap.

Switzerland's negative rate strategy: The Swiss National Bank adopted negative rates in December 2014 (–0.25%) to fight appreciation of the Swiss franc, which threatened exporters. The policy succeeded in weakening the franc and boosting asset prices. However, the SNB faced fierce political criticism from savers and retirees losing purchasing power. In 2015, the SNB abandoned the franc's euro peg entirely, accepting a temporarily stronger franc in exchange for exiting negative rates.

Numeric example: From 2014 to 2019, the ECB's deposit rate fell from –0.1% to –0.5%. During this period, eurozone bank NII (net interest income)—the profit from lending minus the cost of deposits—compressed significantly. For example, Italian banks saw NII decline as a share of total income because they struggled to lower deposit rates below a certain floor without triggering deposit flight. Banks responded by slashing costs, reducing headcount, and taking on more risky loans (reaching for yield) to maintain profitability. This side effect—riskier loan origination—was a cost of negative rates.

The side effects and costs​

Negative interest rates carry substantial unintended consequences that policymakers must weigh against the limited benefits.

Harm to bank profitability: Banks are squeezed from both sides. On the liability side, they cannot lower deposit rates much below zero without customers withdrawing cash. On the asset side, lending rates are constrained by competition and the borrower's willingness to pay. The spread narrows, bank profits fall, and banks cut costs by laying off staff, reducing lending, or taking on more risk.

Punishment of savers and retirees: Negative rates represent a transfer from savers to borrowers. A retiree with $1 million in savings earning 2% used to receive $20,000 per year in income. With negative rates, she receives nothing or even loses money. This is politically unpopular and creates public backlash against central bank independence.

Distortion in asset markets: With returns on savings negative and central banks desperate to stimulate, asset prices (stocks, real estate, cryptocurrencies) inflate beyond fundamental values. Investors search for yield, bidding up risky assets. This creates bubbles that eventually pop, causing financial instability.

Capital flight: Negative rates on domestic deposits encourage wealthy individuals and firms to move money abroad to countries with positive rates. A Swedish company with excess cash might deposit it in U.S. banks earning 0.5% rather than paying to hold it at the Riksbank. This capital outflow weakens the exchange rate and reduces the domestic money supply.

Reduced financial intermediation: With profitability threatened, banks may reduce lending standards-tightening to preserve margins, or they may exit certain markets. In the eurozone, small and medium-sized business lending remained tepid despite negative rates partly because banks were retrenching.

Political economy deterioration: Negative rates inflame public opinion against central banks. Savers view the policy as confiscatory. Labor unions demand wage increases to offset losses. Politicians attack central bank independence. The loss of central bank credibility and independence can undermine future policy effectiveness.

The political economy: why negative rates are limited​

Central banks cannot push interest rates very far into negative territory because political and economic constraints bind.

The cash constraint: As explained, people prefer holding cash to earning negative returns on deposits. If a central bank tries to go deeply negative (say, –3%), the public will withdraw enormous amounts of cash. The central bank cannot compel people to hold bank deposits. This limits the effective lower bound to roughly –0.5% to –1% for most developed economies.

The political constraint: Savers—often older, politically powerful voters—oppose negative rates violently. If a central bank tries to implement –2% rates, politicians will face pressure to restrict the policy or constrain the central bank. In some cases, governments have considered capital controls to prevent capital flight. But such controls are economically destructive and politically difficult to sustain.

The credibility constraint: If the central bank is seen as charging savers to fund profligate borrowers, it loses credibility and political support. This can undermine the central bank's primary tool—the expectations channel. If the public sees the central bank as captured or desperate, forward guidance becomes less powerful.

The international constraint: If one country adopts deeply negative rates and others do not, capital flows to positive-rate countries, weakening the negative-rate country's exchange rate. This invites retaliation—other countries adopt negative rates too. A global race to negative rates benefits no one because the relative returns remain unchanged.

A diagram of negative rate mechanics and constraints​

Real-world examples​

The ECB's 2014–2019 experiment: The ECB was facing deflation fears in 2014—inflation was at 0.4%. The central bank cut the deposit rate to –0.1% in June 2014. Eurozone banks complained immediately about shrinking margins. Yet inflation did not accelerate as hoped. The ECB deepened the cut to –0.5% by September 2019, the lowest in the world. Eurozone inflation remained around 1%, far below the ECB's 2% target. Despite negative rates for five years, the ECB ultimately concluded that the side effects (bank stress, financial stability risks, political backlash) were approaching the limits. In 2021–2022, as inflation spiked due to fiscal stimulus and supply shocks, the ECB eventually raised rates off negative territory.

Japan's 2016 negative rate gamble: The BOJ, facing persistent deflation, adopted –0.1% in January 2016. The yen weakened modestly, which helped exporters. But inflation expectations failed to shift—the public remained convinced deflation would persist. Within months, the BOJ acknowledged disappointment and shifted strategy, implementing "yield curve control" (targeting specific long-term rates) rather than pushing rates deeper negative. The BOJ's negative rate period was brief (2016–2021) and modest in scale.

The Swedish Riksbank's extreme approach: Sweden's Riksbank pushed rates to –0.5% in February 2015, the deepest in the world at the time, with the goal of weakening the krona. But capital flight accelerated—wealthy Swedes moved money to Norwegian and U.S. banks. Political opposition mounted. By 2018, faced with rising inflation from global commodity prices and tight labor markets, the Riksbank began hiking toward zero and exited negative rates entirely. The policy is now viewed as having had modest success in weakening the krona but substantial costs in capital outflows and political credibility damage.

Common mistakes​

Mistake 1: Assuming negative rates are as effective as positive rate cuts. Negative rates are weaker than positive cuts because they face the cash constraint and political opposition. A central bank pushing from 0% to –0.5% has less impact than pushing from 2% to 1.5% because the –0.5% rate is near the effective lower bound.

Mistake 2: Believing negative rates purely transfer wealth from savers to borrowers. While that's part of the story, negative rates also reduce overall financial system health by harming bank profitability. The effect is not a zero-sum transfer but a reduction in total economic welfare for savers without proportional benefit to borrowers.

Mistake 3: Thinking negative rates can force lending growth. Banks won't lend aggressively just because reserves are costly. If borrowers lack profitable projects or are over-leveraged, no rate is low enough to spur lending. This was the lesson from Japan's experience: negative rates cannot overcome the fundamental problem of weak demand and broken balance sheets.

Mistake 4: Ignoring the political economy limit. Negative rates can only go so far because voters oppose them. A central bank that pushes too far will face political pressure to restrict its independence or constrain its policy. This political economy limit is often overlooked by economists focused on technical transmission mechanisms.

Mistake 5: Confusing real and nominal rates. In deflation, negative nominal rates may not be truly negative in real terms. If inflation is –1% and the policy rate is –0.5%, the real rate is 0.5%, which is still contractionary. To be truly accommodative in deflation, the central bank might need to tolerate positive inflation expectations, not just negative nominal rates.

FAQ​

Why would anyone accept a negative-rate bank account?​

They wouldn't, voluntarily. But in some countries, large institutional deposits (corporate and government) are required to hold funds at banks, and savers have limited alternatives. For deposits above insurance limits (like FDIC coverage in the U.S.), moving the money is complicated. This is why negative rates mostly affect institutional deposits and the interbank market, not retail savings. A retail saver would simply withdraw cash.

Could negative rates ever go significantly negative, like –5%?​

Not in a system with physical cash. If rates fell to –5%, everyone would withdraw cash. The central bank would have insufficient physical cash to meet demand. But in a cashless society where cash is eliminated, rates could theoretically go deeply negative because there would be no alternative. Some futurists speculate about this, but eliminating cash is politically infeasible in democracies.

Do negative rates help or hurt the poor?​

It depends on the structure. Negative rates reduce bank profitability and can lead to higher fees, reduced services, or branch closures in low-income areas. Lower-income households are more likely to use cash (which earns 0%) or simple savings accounts, so they are harmed by the reduced returns. Wealthy households can invest in stocks or other assets and benefit from the asset price inflation negative rates create. So negative rates tend to worsen inequality.

Could a central bank use negative rates on all deposits, not just reserve deposits?​

Not effectively. If the central bank charged retail depositors negative rates directly, they would withdraw cash immediately. In practice, negative rates on central bank reserves affect bank deposits indirectly through the interbank market. Banks then have some discretion over whether to pass the cost to retail customers. Most don't, to avoid deposit flight.

If negative rates don't work very well, why do central banks use them?​

Because when facing persistent deflation and zero rates with weak growth, central banks feel compelled to "do something," even if that something is of questionable efficacy. Negative rates show the public and politicians that the central bank is not sitting idle. They also provide marginal stimulus through asset prices and the signal of commitment to fighting deflation. Moreover, central banks in desperate situations may believe negative rates, while imperfect, are better than doing nothing.

Can negative rates and quantitative easing work together better than either alone?​

Yes. Negative rates plus QE (large asset purchases), plus fiscal stimulus, plus depreciation of the currency, can overcome deflationary pressures. But isolating the effect of negative rates alone is hard. Japan's recovery from deflation came not from negative rates in 2016 but from the combination of Abenomics (QE + fiscal stimulus + structural reform) starting in 2013, plus global economic recovery in the 2010s.

Summary​

Negative interest rates are an extreme monetary policy tool deployed when a central bank faces persistent low inflation or deflation and standard tools like positive rate cuts and quantitative easing have failed. By charging banks to hold reserves, the central bank hopes to push lending and discourage saving. However, negative rates face substantial constraints: the effective lower bound (around –0.5% to –1%), below which people prefer cash; political opposition from savers and retirees; bank profitability pressure; and capital flight risks. Evidence from the ECB, Bank of Japan, and other central banks suggests negative rates provide modest stimulus while creating significant side effects. They are a tool of last resort, revealing central bank desperation rather than confidence in future economic recovery.

Next​

→ Helicopter money explained