Many foreign central banks—such as the European Central Bank, the Bank of Japan and the Swiss National Bank—have implemented negative interest rates on bank reserves as a policy tool to stimulate demand for goods and services. If a bank holds a dollar of reserves, the central bank may take, say, half a cent.
The hope is that a negative interest rate will induce firms to lend out the reserves by charging a lower interest rate on loans. In short, “use it or lose it.” More lending would stimulate spending on goods and services, which would lead to higher output and upward pressure on inflation.
Essentially a negative interest rate is just a tax on the banks’ reserves. The tax has to be taken on by someone:
- The banks can choose not to pass it on and just have lower after-tax profits. This will depress the share price of banks and weaken their balance sheets by having lower equity values.
- The banks can pass the tax onto depositors by paying a lower interest rate on deposits or charging them fees for holding the deposits. In either case, depositors have less income to spend on goods and services.
- The bank can pass the tax onto borrowers by charging them a higher interest rate on a loan or higher fees for processing the loan. In either case, it is more costly to finance purchases of goods and services by borrowing.
Please understand Negative interest rates don’t necessarily mean lower interest on loans. That is up to each bank individually, not the Fed.