What are negative interest rates and how do they work?

By Niko Iliakis ·

The Reserve Bank of Australia (RBA) may have held off on lowering the official cash rate this August, but many are betting that the third cut of the year is just around the corner. And if the RBA does go ahead and pull the lever, official interest rates in Australia will be hovering pretty close to 0%. 

Whether or not things will reach that point is an uncertainty, and depends a great deal on conditions overseas. At a recent hearing at the House of Economics committee, RBA Governor Philip Lowe flagged interest rates at the zero lower bound as a possibility, albeit an “unlikely” one. 

But what would it mean if things reached the zero mark? While the RBA has tools at its disposal it would rather make use of, rates of 0% or below have been the norm for years elsewhere around the world. We take a look at how they work.

First of all, what do cuts to the cash rate mean?

While RBA rate cuts get a lot of attention in the news for their effect on owners and homebuyers, it’s easy to forget that falling interest rates are an indicator that the economy isn’t faring too well.

“The last two cuts were made in response to lacklustre growth and below target inflation and employment figures,” Mozo’s Banking Expert, Peter Marshall reminds us.

“By lowering interest rates, the Reserve Bank hopes to give the economy a much-needed shot in the arm by encouraging people to spend, borrow and invest.”

Related: What is the cash rate and how does it affect you?

The thinking goes that if savings accounts are producing negligible returns, people will be less incentivised to keep their money in the bank and more likely to put it to use in other ways.

In reality, things are less certain, and the effectiveness of monetary policy - particularly in the short term - is a matter of debate. 

Nonetheless, we should see reductions in the cash rate for what they are: an admission that the economy is showing signs of weakness — and an effort by the Reserve Bank to patch up the cracks.

How do negative interest rates work?

In theory, negative interest rates would create a topsy-turvy financial environment, in which savers are charged to keep money in the bank and borrowers are potentially rewarded with interest.

While the idea is to turbocharge spending and investment, there are plenty of ways that this might backfire in practice. For example, negative or extremely low interest rates could put a strain on banks’ profit margins, potentially reducing their willingness to lend.

And if banks go as far as charging customers just to hold their money, people might decide to withdraw their savings and hoard their cash at home instead, draining banks of a crucial source of financing.

In many countries where official interest rates have crossed over into the negatives, banks have refrained from cutting savings rates in kind for this very reason, as in Japan, where many savings accounts offer interest rates in the range of 0.001% p.a.

Which countries have negative interest rates?

Interest rates may be close to zero in Australia, New Zealand, the US and elsewhere in the world, but plenty of countries have already crossed over into negative territory. 

Back in 2009, after the global financial crisis hit, Sweden became the first country to take official interest rates below zero, making it a pretty important case study among economists worldwide. Other parts of Europe, such as Switzerland and Denmark, followed soon after.

Japan made headlines when it adopted negative interest rates in 2016, after multiple stimulus packages - deployed after its real estate and stock market bubbles burst in the 90s - failed to revive an economy in steep decline.

So far, negative interest rates haven’t done much to improve Japanese economic performance, and the picture is still one of sluggish growth. In fact, some commentators have pointed to the situation in Japan as evidence that the strategy is misguided.

What should you be doing now?

If we look at the immediate impact on personal finances, then super low interest rates paint a favourable picture for homebuyers and mortgage holders. Currently, the outlook for those with their sights on the property market is positive.

That said, the tepid response by most banks to July’s cut suggests we’re already looking at a case of diminishing returns, and we’re still far off from a cash rate of zero. With each future reduction, banks will withhold more and more to make sure they maintain a healthy margin between the loan and deposit rates they're offering. 

As for savers, they don’t have much to be optimistic about. Many savings accounts, particularly those from the big banks, offer ongoing rates in the zero to one percent range already. 

With such low rates, older Australians who might be relying on interest from their savings as a source of income have been handed a raw deal. Further reductions would put an even greater dent in their retirement earnings.

So if your current savings account leaves a lot to be desired, it might be a good idea to start shopping around. Have a look at some of the options below, or visit our savings account comparison page to get an idea of what else is available.

Savings account comparisons on Mozo - page last updated September 19, 2020

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