Remember when interest rates were just “low” and “ultra-low”? In today’s world of unorthodox central bank policy, negative interest rates appear to be the new norm. In what follows, we offer some background on what it means, and discuss a few byproducts of negative interest rates and some potential implications.

What is the difference between nominal and real interest rates?

Real interest rates adjust for inflation and account for the true cost of borrowing. Nominal rates — the rates quoted most often in the media — are not adjusted for inflation.

Why does the real rate matter?

The inflation adjustment reflected in the real interest rate can turn a positive nominal yield into a negative real yield.

For example, if a bank sets the nominal rate at 1% annualized and inflation is 2% a year, the real rate would be effectively negative 1%. In this case, a deposit of $1,000 put into a bank would grow to $1,010 after 12 months, but be worth $989.80 in terms of buying power after inflation. In other words, depositors can lose purchasing power when bank deposits earn a negative rate.

How are rates related to bond yields?

Short-term interest rates are part of something bigger — the yield curve, or term structure of borrowing costs in the economy. The yield curve indicates the cost of borrowing for periods ranging from one day to 30 years. As a part of the yield curve, short-term rates can influence almost every other borrowing rate in the economy.

How did sovereign bond yields turn negative?

There is an estimated $12 trillion dollars of sovereign bonds with negative yields due to the market pricing of bonds. For example, a Swiss 30-year bond recently had a coupon of approximately 4% and a price of 234 francs. This means that if an investor purchased the bond today and held it to maturity, the investor would receive less than face value. The reason why is that the amortization of the premium, which reduces the proceeds, would be more than the value of the interest payments over the life of the bond.

How are banks and central banks involved in negative rates?

Short-term rates set by central banks have a specific impact on the banking or financial system, and through the financial system, on the rest of the economy. Large banking institutions also hold reserves at central banks, such as the European Central Bank, the U.S. Federal Reserve, and the Bank of Japan. A central bank acts, in effect, as a warehousing facility for any excess reserves for the banking system, and its policies, including interest rates such as the federal funds rate or the ECB’s deposit facility rate, have an impact on the costs of short-term borrowing in the banking system.

Why do central banks establish negative interest rates?

The goal of negative-interest-rate policies is to encourage banks to stop hoarding money and, instead, to lend it and stimulate growth. This was one reason that the ECB made its deposit facility rate — the rate that banks receive for depositing money overnight at the ECB — negative in June 2014. With a negative rate, banks pay interest rather than earn interest on their deposits, and therefore should be motivated to lend more to consumers and to businesses, in turn boosting the broader economy. At least that is the theory. The overnight interest rate is the basis for nearly every other interest rate including those on retail bank deposits, certificates of deposit (CDs), mortgages, and auto loans. The belief is that a negative-interest-rate policy has the potential to make it cheaper for everyone to borrow money. The ultimate policy objective is to stimulate economic activity and growth, which would help ease fears of deflation — a concern in Japan and parts of Europe today.

Have interest rates been negative before?

Although they are unfamiliar, negative rates are not new. Denmark established negative interest rates as early as 2012 after giving the world ample warning. Contrary to concerns at the time, this did not cause a meltdown in Denmark’s financial system. Nor did it lead to a noticeable change in the various interest rates charged by Danish banks on their loans to consumers and businesses.

However, it is difficult to gauge whether a similarly mild effect is likely to occur in larger economies, such as Switzerland, Sweden, Japan, and the European Union. In these economies, the experiment with negative rates has a shorter track record.

What are the byproducts of negative rates?

Perhaps the most obvious effect of negative central bank interest rates is that they have magnified the downward pressure on government bond yields. As the spreading contagion of negative yields in our table shows, this pressure is widely felt across the bond-maturity spectrum in many European countries and in Japan.

Another consequence is that negative interest rates are likely to have an adverse effect on bank profitability, especially in a flattening-yield-curve environment. Banks will face margin pressure and reduced profits because they have been absorbing the costs of paying to deposit funds at the respective central banks and have not been passing on the additional costs to customers. That is not written in stone, however, and some banks have even begun charging customers for deposits in Switzerland and Japan.

What are the remaining uncertainties?

The unconventional monetary policy of negative rates is untested, which makes drawing any sure conclusions a difficult task. Ultimately, negative rates in Europe and Japan may stimulate economic growth. But they may also have undesirable and unforeseen economic and financial consequences — including misinterpretations by individuals and businesses alike, who, reading desperation in central bank actions, may be inclined to hang on to their money rather than invest or spend. It will take time to measure the positive and negative effects and reach a meaningful evaluation of the experiment.