What are negative interest rates and how do they work?

The Reserve Bank of Australia moves interest rates up and down to influence supply and demand. If economic growth is slow, the RBA might decide to cut interest rates to stimulate spending and investment. But is there a chance they could drop to zero? Or even lower?

RBA governor Philip Lowe has been quite candid about his distaste for negative interest rates in the past. In a November 2020 speech, he said there is little to be gained by taking rates negative, and that it was “extraordinarily unlikely” the unconventional policy would be adopted in Australia. 

“While a negative rate might lead to a helpful depreciation of the Australian dollar, it could impair the supply of credit to the economy and lead some people to save more, rather than spend more,” he said.

In fact, the closest the RBA has come to saying something positive on the matter was when deputy governor Guy Debelle said the “empirical evidence on negative rates is mixed.” Not exactly a glowing endorsement.

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 during an economic crisis, rates of 0% or below have been adopted by central banks around the world. We take a look at how they work.

If we look at the immediate impact on personal finances, then low interest rates paint a favourable picture for homebuyers and mortgage holders. The graph below shows how home loan interest rates have moved with each reduction to the cash rate over the past few years.

Of course, lenders aren’t obligated to pass on any cuts to their customers in full. There are plenty of factors they need to consider, such as maintaining a healthy margin between the loan and deposit rates they’re offering.

On the other hand, savers won’t have much to be optimistic about, particularly those who rely on interest as a source of income.

But while reductions to the cash rate get a lot of attention for their effect on owners and homebuyers, we shouldn’t lose sight of the fact that falling interest rates are an indicator that the economy isn’t faring too well.

Cuts are usually made in response to lacklustre growth and below target inflation and employment figures. 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.

This could play out in a few ways. Besides the obvious appeal of low borrowing costs, some think that if savings accounts are producing negligible returns, people will be less willing to keep their money idle in the bank and more likely to put it to use in other ways.

In reality, things are much less certain, and the effectiveness of monetary policy - particularly in the short term - is a matter of debate. This goes doubly so during crises like this one, where precautionary savings are on the rise.

Average variable home loan rates in Australia

Commercial banks have deposit accounts with the RBA, and they receive interest on these accounts just like an ordinary Australian would on their savings account.

If official interest rates drop below zero, then all of a sudden banks will have to start paying interest to the RBA. The hope, of course, is that they will balk at the very idea, withdraw their cash reserves, and lend it out to customers instead.

While the idea is to turbocharge 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 the cash rate drops so low that consumer interest rates are dragged down with it, it could create a topsy-turvy financial environment, in which savers are charged to keep money in the bank and borrowers are potentially rewarded with interest.

Banks are wary of how this would impact consumer sentiment. E.g. if they are pushed to charge interest on deposits, customers 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 dipped into the negatives, banks have refrained from cutting savings rates in kind for this very reason, as in Japan, where many savings accounts would offer interest rates in the range of 0.001% p.a.

Back in 2009, after the global financial crisis hit, Sweden became the first country to take official interest rates below zero, making it an 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.

It's not unheard of. In 2019, Jyske Bank, one of Denmark's largest banks, began offering mortgages with interest rates of -0.5% p.a. In this arrangement, borrowers make repayments as usual, but their outstanding balance is decreased by slightly more than is paid off at each instalment.

By the time the mortgage has been paid off in full, borrowers will have contributed less than what the bank originally loaned them. While this means customers are essentially getting paid to borrow, it's not necessarily the case that it's coming out of the bank's pocket.

But why would a bank do this? Rates in Danish money markets are well below zero at the moment, so if a commercial bank is able to price its home loans at a higher rate than what it's charged on loans from the central bank, then there's still a profit to be made.

While the RBA has shown a clear bias against negative interest rates, we can’t rule it out as a possibility in the future.

Whether or not we’ll go down that path depends a great deal on conditions overseas, especially in the US. That’s because decisions made by the US Federal Reserve tend to have knock-on effects on the Australian dollar.

Generally speaking, when interest rates fall in the US, the Aussie dollar rises as global investors scramble to park their money in Australian accounts (which all of a sudden become much more attractive).

A strong dollar isn’t always good news. It means that Australian exports become much more expensive in foreign markets, giving overseas buyers incentive to import from other countries with a lower exchange rate.

So if other central banks around the world continue to cut their interest rates, the RBA could face pressure to do the same, largely to offset these effects.

For more information about the cash rate and how it affects households’ finances, visit our home loan statistics page, where we provide a historical overview of the home loan market in Australia.