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Too low for zero: How negative interest rates will work

Stephen Koukoulas
·4-min read
Green helium balloon carrying pink piggy bank with white strings on blue sky.
Too low for zero: How negative interest rates will work. Source: Getty

There is a lot of chatter about negative interest rates and the distinct possibility our own Reserve Bank of Australia will be forced to cut the official cash rate below zero as it tries to support an economic recovery and get the annual inflation rate to return to the 2 to 3 per cent target range.

To be sure, the RBA Governor, Philip Lowe is dead against negative interest rates even though the experience globally is that they do help to support an economy by creating incentives for the big financial institutions and companies to invest.

Before you get too excited, the discussion here about negative interest rates will not translate to your mortgage and overdraft interest rates. They will remain positive, although will continue to gravitate to record lows.

Negative interest rates are designed, broadly, to drive the business sector to invest and not sit on stockpiles of cash.

A problem now for the economy is the attitude to risk from the big companies. With business investment tracking at depressionary lows, it is clear that the bulk of big businesses are preferring to hold and accumulate cash rather than invest it. They are doing this even with the return on savings at current interest rates at a tiny fraction above 0.0 per cent.

Businesses are doing this to preserve their capital. They are, generally, unwilling to put their money at risk by lending it or investing it, when there is a chance the recession will make those loans go bad and money will be lost as a result.

If the RBA goes negative

The official cash rate “is the interest rate on unsecured overnight loans between banks”. This definition from the RBA shows that it is of little direct relevant to the interest rate you and I pay on our mortgages, credit cards and business loans.

If interest rates do fall below zero, it will cost the banks and other institutions to save money. The strategy of negative interest rates from central banks is to make this penalty sufficiently painful that money will be lent to businesses and households alike at an interest rates above zero and in the process drive investment, hiring and the reflation of the economy.

Or looked at another way, the banks have an option of savings its cash with an interest rate of (say) -0.5 per cent, which costs it money and erodes profits, or lend on mortgages at 2.5 per cent, or business loans at 3 or even 4 per cent.

As noted, lending to householders and business is more risky than holding deposits. Some loans will go bad. But in a climate where an economic recovery is complemented by fiscal policy stimulus, the risk of bad loans can be minimised and, it is hoped, the banks make more money than will be lost by saving at negative interest rates.

The global experience

Several central banks including the European Central Bank, in Denmark, Japan, Sweden and Switzerland has set their official rates below zero. The economic performance in those areas has been enhanced by such easy monetary policy.

Of course, negative interest rates are a reflection of poor economic conditions and are not the magic solution to all economic ills. But to the extent they encouraging lending and investing, they make economic conditions better than they would otherwise be.

Negative rates for savers? It can’t work!

There is an interesting discussion when it comes to the consideration of negative interest rates on deposits.

With negative interest rates, if you have $1,000 in savings and deposit it with the bank for a year at -0.5 per cent, the balance in 12 months will be $995. You have ‘lost’ $5.

Clearly, there is a massive incentive for householders not to leave money on deposit and rather, to withdraw the cash and hold the cash ‘under your mattress’ or in a safe. After a year, you will still have $1,000.


It remains unclear whether the RBA will need to cut rates to below zero. If there is even a moderate economic pick up over the next few years, it can avoid such action. But if there is a double dip recession or if growth remains sluggish, inflation low and unemployment high, it may be forced to.

It will create an interesting policy debate but don’t think it will mean the banks will be paying you to take out a mortgage!

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