What exactly are negative interest rates anyway?

Bank of Canada governor Stephen Poloz this week revealed the central bank might be willing to follow the lead of some of its European counterparts by dropping interest rates below zero—but only if faced with a severe 2008-style economic crisis. And even then the floor would be established at minus 0.5 per cent. Still, the policy shift is notable, considering Canada’s central bank previously said it couldn’t see cutting its key lending rate below 0.25 per cent (it’s currently at 0.5 per cent after two cuts earlier this year). So what’s changed? Paul Beaudry, an economics professor at the University of British Columbia, explains Poloz’s new thinking and how negative rates could play out for consumers if they were actually implemented in Canada.

Q: How do negative interest rates work, and why were they previously off the table?

A: The previous notion of being unable to go below zero was pretty easy to understand. If you did that, we thought, people would just hoard their cash. If someone told you they would give you $9.90 next year if you deposited $10 in their bank, you’d say, “I will just keep my dollars in my pocket.” That was the standard logic.

But big banks move around a lot of money—millions each day—and the standard procedure is to keep money, electronically, at the Bank of Canada that can be used to pay other banks. They sort of use it as their bank. So negative interest rates would mean the Bank of Canada would start charging big banks to deposit money. Now, of course, the banks could just say, “We’re not going to do that anymore,” and deal in actual cash instead. But that’s very costly. And that’s what we didn’t know before—just how costly it was. Banks in Europe are finding it’s still better to pay a quarter per cent to the central bank (The ECB recently dropped its deposit rate to minus 0.3 per cent from minus 0.2 per cent) than to move cash around in a Brink’s truck. Now, if you decided to drop rates to minus five per cent, banks would stop doing this. They would find ways to get around it. So it’s really just a question of trying to figure out how far you can go.

Q: If the Bank of Canada were to go down this road, would negative interest rates be passed along to consumers?

A: Not really. Think about what’s happening. The banks are always trying to decide whether to lend money to you or keep it at the Bank of Canada and do something else with it tomorrow. So if the alternative is keeping it at the Bank of Canada, which costs them money, they will tend to charge you less interest on loans. That’s how it gets passed through.

Q: But haven’t there been banks in Europe where consumer services like bank accounts and mortgages now come with negative interest rates? (Thousands of Danish homeowners are now paying the bank principal minus interest each month on their mortgages, according to the Wall Street Journal, although it’s not something the banks advertise).

A: You can’t get someone to use a savings account that’s negative, since you could always just keep the cash. But you could go into the negative on, say, a chequing account because there’s a convenience associated with being able to do those transactions. So this is the thing we’re noticing, you can go into the negative and people will still use some services. That’s different from what we thought before. Still, for the consumer, it’s mostly about pushing the cost of borrowing money even closer to zero.

Q: So, how low can you go?

A: We can maybe go down to minus 0.3 per cent, minus 0.4 per cent or even minus 0.5 per cent. Remember, this is an experiment. Countries in Europe are seeing how far they can go. The whole idea is to force banks to lend money instead of keeping it at the central bank.

Q: Are there any downsides to pursuing negative interest rates?

A: You run the risk of people trying to play games. Some people might realize, “The more I borrow, the more I make money.” There are questions about whether people would find ways to game the system and create instability—borrowing large amounts of money and then trying to pay it back. What we’ve found out so far is there aren’t too many tricks. But people are still worried about it. The Bank of Canada could have explored negative interest rates a few years ago, but it’s been fairly conservative. Now, after seeing other central banks do it, they’re putting it in their arsenal in case they really need it.

Q: Poloz said he has no plans to implement negative interest rates or any other “unconventional” monetary tool. But one wonders if it’s only a matter of time, given the way things are going in the Canadian economy.

A: Given that we live next door to the U.S., which is likely to increase rates in the short-term, I think it’s highly unlikely. Now if something really bad happened—if China started to collapse, for example—there would be a lot of countries suddenly moving in the same direction [to loosen monetary policy] again.