A negative interest rate is an interest rate with a negative value. The point is that interest rates shall not fall below zero. So how is a negative interest rate possible? There could be a couple of reasons.
1. Real interest rate becomes negative due to inflation
The real interest rate calculation formula is:
Real rate = Nominal rate - Inflation
For example, if a bank set the nominal interest rate at 3% and if the inflation is 3.5% a year, the real rate will be negative (-0.5%). In this case, if you put $100 in the savings account, normally, it should be $103 after one year. However, after inflation, it will be $99.50. As you see, as a depositor, you lose $0.50.
2. Nominal rate turned negative due to deflation
It means that instead of receiving money on deposits, you must pay a fee to the bank for keeping your money there. Why is it so? When the country’s economy goes into deflation, people and businesses try to accumulate their savings instead of investing or spending money. As a result, the economy goes into recession because aggregate demand is decreasing.
To prevent this, the central bank begins to charge negative interest. This encourages depositors to invest and spend money instead of paying a fee to keep it. In this case, a negative interest rate acts as a monetary policy tool.
In 2014, the European Central Bank (ECB) cut the interest rates to below zero (set depositary interest rates at -0.4%). Denmark, Sweden, and Switzerland, which are not part of the eurozone, also have negative rates.
In 2016, the Bank of Japan also reviewed its economic policies and began to charge a negative interest rate.