What are negative interest rates?
For most people, it starts when they take out their first loan. Others don’t really think about it until they buy a house. But whoever you are and whatever you do, at some point you’ll have to start paying attention to it.
I’m referring, of course, to interest rates.
Interest rates are one of the many mile markers that separate adulthood from childhood. (You always know someone’s growing up when they start having to worry about interest rates.) But here’s a three- letter term even some adults haven’t heard of: negative interest rates.
While you probably haven’t seen the term in the headlines of your local paper, it’s become a common topic in global financial circles. That’s why it’s a good idea to familiarize yourself with the concept, because there’s a chance you’ll see it much more often in the future.
First, the basics. What exactly are negative interest rates? Investopedia has a good definition:
A negative interest rate means [a nation’s] central bank and perhaps private banks will charge negative interest: instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe.1
Since the Great Recession of 2008, many countries have done almost everything in their power to help their respective economies grow. One way to do that is to keep interest rates low. Lower interest rates make borrowing less costly, which means businesses and individuals can borrow and spend more, thereby pumping more money into the economy as a whole. This, of course, equals growth.
The United States has been no stranger to this tactic. Our own central bank (the Federal Reserve) kept interest rates low for years. Only in late 2015 did the Fed finally raise rates, and the increase was very small, going from 0–0.25% to 0.25–0.5%.2
But what happens if a central bank takes interest rates all the way down to zero, and it still isn’t enough to kick start the economy?
That’s when negative interest rates come into play. It’s like hanging a carrot from the end of a stick, then telling the rabbit it has to either eat the carrot or lose a percentage of the food it already has.
What are the consequences of negative interest rates? It depends. For consumers, negative interest rates can mean that taking out a loan to start a business or buy a home becomes much more attractive.
Existing loans or mortgages with negative interest rates also become much easier to pay off. On the other hand, simply keeping your money in a savings account becomes less attractive, since you will probably have to pay interest rather than earn it.
For banks, negative interest rates can be harmful. After all, most banks rely on high interest rates to make money. The less money they earn, the less money they have to lend—meaning less business overall. That puts banks in danger of failing, which as we know from our own national experience, can plunge a country into recession.
Fortunately, most banks are aware of the risk and take steps to reduce it. For instance, they may apply negative interest rates only to certain types of accounts and transactions. Above all, though, central banks rely on negative interest rates to increase borrowing and spending, thereby boosting the economy and making long-term growth more likely.
As of this writing, several countries have dipped into negative interest rate territory. For example, Japan went to -0.1% in February.3 The European Central Bank followed in March. Nations like Denmark and Sweden have already instituted negative interest rates. What about here in the United States? Back in November of 2015, Janet Yellen, the Chairwoman of the Federal Reserve, acknowledged that negative interest rates are a potential tool for stimulating the economy, but seemed to dismiss any current need for them, saying, “I don’t at the moment see a need for negative interest rates.”4 In short, it’s possible the U.S. might see negative interest rates in the future, but not very likely. It’s more likely that the Fed will continue raising rates, albeit at an extremely slow pace.
What does all this mean for investors? Well, the global economy still remains fragile, which can lead to market volatility here at home. So the fact that more central banks are taking steps to jumpstart their economies is probably a good thing. On the other hand, negative interest rates are also proof that our planet is still a long ways away from economic stability. As a result, we need to remain vigilant and educated so we can continue making the best decisions for your financial future.
Vigilant and educated—that’s why I make it a point to send you letters like this. In the meantime, we’ll keep monitoring the global markets like we always do. But if you ever have questions, about negative interest rates or anything else, don’t hesitate to let us know. We are always happy to hear from you!