The Negative Interest Rate Conundrum

10 July 2020


Since the 1990s interest rates have been declining and remain low across all major advanced economies. In particular, low long-term interest rates reflect the diminishing return on safe assets due to demographic changes, a slowdown in the rate of technological progress, and a high demand for safe assets relative to their supply. The secular decline of inflation and inflation expectations and short-term policy rates either at zero or approaching the zero lower bound (ZLB), makes it even more challenging for expansionary monetary policies to reduce real interest rates to a level consistent with stable inflation and output at its potential level (technically, the “natural” rate of interest).

Traditionally, central bankers have subscribed to the view that the policy rate could not drop below zero, because households and corporates might start converting deposits into cash to avoid devaluation, thus conflating the nominal lower bound with the “physical lower bound”. However, not going below zero percent meant that with inflation remaining low, real rates could not fall further to help reduce high debt burdens and support aggregate demand. 

The efficacy of monetary policy within a near-zero or sub-zero interest rate environment is still under review. Some economists argue that central banks cannot stimulate lending, and may indeed decrease the loan supply, by setting negative interest rates. While others have shown using empirics that negative rates do not impede the transmission of monetary policy from banks to deposit holders because firms do not withdraw cash in response to negative rates the way households might. In fact, sub-zero rates may even stimulate the economy by encouraging firms to invest.

Theoretical Schools of Thought  

Severe economic downturns typically require sustained monetary policy expansion through aggressive and significant interest rate cuts. Over the last four decades, central banks in industrialised countries – such as the Fed, the ECB, BoE and the Bank of Japan – have usually cut rates by around 4% in response to recessions. However, with near zero interest rates prevailing in advanced economies, this would require moving the policy rates into the negative territory more frequently. Maintaining rates in positive territory would limit the policy arsenal that could be deployed to stimulate the economy. Indeed, with policy rates stuck around the ZLB, in 2012 central banks in Switzerland, Sweden, Denmark, Japan, and the euro area had lowered their key policy rates below zero. Inspite of these policy interventions, there is still little consensus within the economic profession on the effectiveness of negative interest rate policies (NIRPs).

Theoretically, there is sustained uncertainty about the effectiveness of monetary policies below the ZLB. One school of thought suggests that monetary policy becomes ineffective below the ZLB. Banks are not be able to lower interest rates on deposits, which in many jurisdictions represent their main source of funding, below zero, because market participants would rather hoard cash. Thus, when short-term interest rates approach zero, central banks would not be able to stimulate lending and demand by lowering short-term interest rates. Moreover, NIRPs could be contractionary because negative rates reduce banks’ profits and coupled with an increasing risk of default, lead to a reduction in loan supply.

Conversely, in an environment of low inflation and a declining equilibrium real rate of interest, negative rates could restore the signalling capacity of the central bank by effectively removing the zero lower bound (ZLB). Moving the marginal policy rate into negative territory can help the real rate adjust downward, compensating for inflation below the inflation target and contributing to a significant flattening of the yield curve. In other words, a decline in the nominal rate could lower its real rate component, allowing inflation expectations to rise and boosting aggregate demand. However, if both nominal and real interest rates are shifted down, a widening gap leads to deflation pressure. Thus, if banks hold excess reserves, cuts to the central bank base rates can effectively lower the interbank and other interest rates, encouraging banks to take greater risks and facilitating portfolio rebalancing.

Assessing the effect of NIRP on exchange rates is difficult since many other factors influence external demand. Negative rates cause exchange rates to depreciate by providing incentives for moving capital to higher-yield jurisdictions. Thus, a widening real term spread differential would put downward pressure on the currency. Higher inflation and inflation expectations in other countries might counter this effect. In addition, the stimulative effect of negative rates on aggregate demand (which is discussed below) and rising asset prices in real terms might offset depreciation pressures on the exchange rate.

Ultimately, it is an empirical question whether the ZLB constitutes a black hole upending the laws of economics or can work pretty much as business as usual. The question is whether the ZLB is a hard constraint and what the consequences are for banks and firms of breaking through the ZLB. Limited experience of NIRPs and constraints on data availability have acted as material impediments in proving a definitive answer to these questions.

Financial Stability

Monetary Policy Transmission

Some of the evidence collated together in a range of academic studies within the EU suggests that NIRPs do not hamper the transmission of monetary policy. Banks are still able to transfer negative rates on to deposits. While a ZLB may be binding for household deposits – which, being relatively small, may be easily withdrawn and held as cash – large corporations operating in tax-compliant economies under mature regulatory frameworks are unable to conduct their operations seamlessly without bank deposits. Concurrently, smaller firms, having limited external financing alternatives, are not in a position to risk jeopardising their bank relationships and access to credit by withdrawing when banks charge negative yields on their deposits.

Banks in the euro area started charging negative rates on corporate deposits after the ECB’s Deposit Facility Rate (DFR) became negative in June 2014. On average, interest rates became negative for around 5% of total deposits and around 20% of corporate deposits in the euro area as a whole[1]. In Germany, deposits remunerated below zero account for 15% of the total deposits and around 50% of corporate deposits, indicating that the effects are economically relevant. However, the incidence of negative rate deposits is unevenly distributed over the EU banks with the ability to pass on negative rates being largely concentrated around the highly-rated, well-established, big banks.


The ability of banks to generate profit is imperative not just for the sustainability of the banking system, but also for a sufficient and efficient credit supply to the whole economy. A potential risk of NIRP is that it may hurt bank profitability, thereby posing a threat for financial stability.

Evidence suggests that top tier banks with sound financial ratings do not experience deposit outflows even with the imposition of negative rates. On average, deposits increase during the NIRP period, as is consistent with high demand for liquidity and safe assets. Deposits appear to increase to a somewhat larger extent in sound banks, which charge even more negative interest rates on new deposits during this period. In summary, the constraints typically associated with a ZLB arise only if agents lack confidence in the banking system.

There is little consensus on the impact of negative interest rates on bank profitability. While net interest margins may decrease, a policy rate below zero tends to facilitate capital gains from rising asset prices. Furthermore, a negative interest rate environment may have a stimulating impact on the economy, the benefits of which percolates through to the banking system by improving borrower creditworthiness and reducing banks’ funding costs.

Recent banking data within the Eurozone signals a steady weakening of the loan to deposit interest margins following negative interest rates while concurrently experiencing a squeeze in profit margins on the standard banking maturity transformation of short-term funding and long-term lending resulting from the flattening of the yield curve. Whether these translate into a decline in profitability of European banks is still an open debate in empirical literature. Some recent studies point to evidence that unusually low interest rates combined with an unusually flat term structure erode bank profitability while others conclude that changes in the level and the slope of the term structure are not associated with lower bank profitability once the endogeneity of policy measures are incorporated. These studies theorise that adverse impact on net interest margins are largely offset by the positive impact on intermediation activity, credit quality, and capital gains derived from increased asset prices. Overall, atleast for the Eurozone, over time, there is little empirical evidence substantiating a significant negative effect on general bank profitability.

Portfolio Restructuring 

Some studies report a novel corporate channel of monetary policy that is activated when rates are negative. Firms that are exposed to negative rates, on average, increase their fixed/illiquid investments and decrease their short-term liquid assets and cash. Research conducted on the investment patterns of high and low cash-holdings firms theorise that firms with a higher ratio of liquid assets to total assets actively alter their asset portfolio towards less liquid assets and out of cash following NIRPs. The studies conclude that this manifest difference in investment behaviour emerges only after the deployment of the NIRP and become more accentuated over time, broadly consistent with the timing of the reduction in the interest rates on corporate deposits beyond ZLB.

There is growing evidence that not only do sound banks in Europe pass the negative rates on to corporate depositors and maintain loan supply, but the transmission mechanism is enhanced by the fact that firms with large cash-holdings more exposed to negative rates decrease their liquid asset holdings and invest more in illiquid/fixed assets in search of return.

The beneficial effects of NIRP on investment that some of these studies uncover does explain to an extent why negative rates do not appear to adversely affect bank profitability across the board in Europe. These suggest that when banks are sound, the NIRP can provide stimulus to the real economy by influencing the behaviour of both banks and firms and that monetary policy transmission can be successful by breaching ZLB.

Granular studies carried out specifically on European banks provide evidence that banks react to negative policy rates by:

  • expanding their loan portfolio in the non-financial private sector
  • substituting their exposure in domestic bonds for foreign bonds and
  • reducing their levels of wholesale funding

From a financial stability perspective, there is a material risk that such strategic shifts might end up facilitating a more pronounced exposure to counterparties with adverse financial ratings in search of supernormal returns. The empirical evidence, however, alleviates some of this concern by providing evidence of only a limited amount of additional risk-taking by relevant banks.

Nominal and Real Rates and Inflation Expectations

Given the really low level of interest rates in many developed economies, negative interest rates are likely to become a key element in the monetary policy arsenal for confronting the imminent unprecedented recession. It is therefore imperative to carefully examine evidence from economies whose central banks have already deployed such policies.

At the core of this issue is the uncertainty about whether negative interest rates would generate the desired expansionary effects on the economy. Although central banks control the nominal interest rate, the real interest rate (nominal rates less expected inflation) is what affects investment and consumption. For example, households are more likely to spend today if the cost of borrowing a pound falls (that is, if the nominal rate declines), ceteris paribus, or if they think an item will be more expensive in the future (that is, if their inflation expectations rise), ceteris paribus. Consequently, the successful transmission mechanism of monetary policy through NIRP is contingent on inflation expectations rising alongside a reduction in nominal interest rates below the ZLB.

Over the last decade, several countries have pursued NIRPs reducing their nominal rates below zero up to varying degrees. However, it is still unclear where the true lower bound lies. Theoretically, interest rates could drop as deep into negative territory as policymakers wish. Practically however, Switzerland and Denmark are the only two European economies to have cut their policy rates to −0.75%, well below other economies pursuing similar NIRPs.

While there are still material differences in the literature surrounding the effectiveness of NIRPs, a key consensus emerging in academic literature is that for NIRPs to be successful, inflation expectations must rise to accommodate a meaningful drop in real interest rates which in turn stimulates consumption, investment and growth. However, evidence suggests that inflation expectations have actually declined following the introduction of negative rates in the EU, Denmark and Japan thereby dampening the impact of the monetary policy transmission. Sweden, perhaps the only outlier in the EU has witnessed an increase in inflation expectations post NIRP, facilitating an amplified reduction in real interest rates and successfully achieving monetary policy transmission to stimulate growth and realise inflation target.

In Europe, inflation expectations had declined in most of the economies following the introduction of negative interest rates. The ECB’s deposit rate has been consistently negative since June 2014, making the euro zone the largest economy to conduct negative interest rate policy so far. However, with inflation expectations diminishing or remaining anchored, in the period following the NIRP, the effectiveness of the expansionary effects of the policy has been largely equivocal. The lack of conclusiveness around this issue of efficacy of NIRP in Europe is partly due to the difficulty in accurately predicting the economic impact without the implementation of NIRP.   

Inflation expectations also fell after negative interest rates were introduced in Japan which provides a particularly interesting case study. Prior evidence suggests that Japan might be in an expectations-driven liquidity trap — in such a trap, producers expect low demand and cut their prices, thereby causing higher real interest rates and low demand due to disinflation. Many economic studies show that if a recession is caused by an expectations-driven liquidity trap, negative interest rates are almost certainly contractionary and decrease inflation expectations even further. Although negative rates may not have caused Japan’s inflation expectations to fall, the country’s low inflation expectations were nevertheless unable to reduce real rates beyond the nominal rate’s decline to −0.1%.

Finally, the financial market reaction to the initial introduction of NIRP across five prominent jurisdictions indicate that government bond yields of all maturities tend to exhibit both an immediate and a persistent negative response to the adoption of such a policy. Furthermore, most medium and longer term interest rates have trended even lower subsequently, which suggests that the ultimate effective lower bound for short-term nominal rates could be significantly below ZLB. Central banks that have yet to introduce negative rates may take some comfort from this evidence as there appears to be room below zero for additional economic stimulus.

Final Thoughts

There is evidence that negative interest rates have contributed to an improvement in overall financial conditions and a modest expansion of credit particularly in the Eurozone. The negative deposit facility rate (DFR) has been effectively transmitted through the domestic credit channel. According to the ECB’s Bank Lending Survey[2], negative rates seem to have led to an increase in household lending and the impact is expected to continue in the future.  

With money market rates shadowing the deposit rate in an environment of excess liquidity, the negative rate also enhances the ECB’s forward rate guidance while inflation and inflation expectations remain anchored. Furthermore, negative interest rates help facilitate portfolio rebalancing which acts as an important transmission channel for the ECB’s asset purchase program. The impact of NIRP on bank profitability has been limited but there seems to be some evidence that monetary transmission begins to shed efficacy as interest rates delve deeper into negative territory. Given that the volume of outstanding loans in the euro area matches the amount of deposits, the transmission of policy rates to lending and deposit rates are fundamental to the earnings capacity of many banks. Estimates of the impact of the decline in policy rates on banks’ NIMs suggest a relatively small effect (7bp for a 50bp drop in the policy rate). Since the adoption of NIRP, however, monetary transmission has become more heterogeneous across the EU, especially for household lending, with a higher transmission in countries with a greater concentration of variable rate loans. While the extent to which deposit rates are sticky at the ZLB remains to be seen, lending rates would be expected to decline more than deposit rates in the near term if cash demand is highly elastic. This is likely to erode the possibility of any further deposit rate adjustments without compromising the net interest earnings of banks. Simultaneously, banks might also be reluctant to reduce lending rates unless they can offset lower interest margins by substituting wholesale funding for more expensive deposit funding, which represents a large part of euro area bank liabilities. If lending rates become stickier, monetary transmission could become impaired, reducing the effectiveness of negative interest rates as a policy measure.

Some of the evidence compiled till date suggests that the adverse impact of negative rates on bank profitability may increase non-linearly as the policy rate declines further. Admittedly, higher aggregate demand and asset quality help raise investment income, lower funding costs and provision expenses, which in turn mitigates the adverse impact on bank profitability in the euro area and support the notion that the economic lower bound to NIRP might be much lower than the ZLB. However, these benefits have weakened over time, especially in countries where the transmission of policy rates is high and the demand for credit is subdued; thereby limiting the extent to which banks are able to increase lending to offset the impact of lower lending rates.

Deteriorating investor confidence and an increasing shift towards risk averseness during any crisis has the potential to intensify the adverse impact of negative rates. Equally challenging would be the prospect of low policy rates for an extended period of time, amplified by structural challenges to banks especially in countries where the cost of risk remains high due to a large stock of impaired assets. Any degree of sustained reductions to the deposit rate could further weigh on banks’ profitability, with capital-constrained banks reverting to reducing lending despite declining rates.

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[1] ECB Data

[2] (ECB, 2020a)