The European Central Bank took a dramatic step on June 5, cutting its main policy rate slightly to 0.15 percent. Bank President Mario Draghi also indicated that quantitative easing will likely come to Europe in the near future. But the most intriguing development is that they are also going to cut another rate — the deposit rate — to negative 0.10 percent, which will make the ECB by far the biggest and most influential central bank to try the negative interest rate trick. In effect, banks will be charged a fee for holding idle money rather than lending it out. In theory, that could help boost demand in the Eurozone at a time when unemployment remains very high and inflation is well below 2 percent.
So what exactly will this mean?
When banks have excess reserves, they can stow those reserves at the central bank and earn interest on them, sort of like how you earn interest on a CD or a savings account at your bank. But the ECB's move would lower the ECB's deposit rate into negative territory, so banks would have to pay for the privilege of depositing their money at the ECB. Currently, the ECB's deposit rate is at zero. Current reports don't say exactly how far below zero the ECB will go.
Negative interest rates? That's insane.
It is really the opposite of how we think about interest rates — if you put your money into a savings account, it should earn at least a little money, right? But an interest rate in part acts as an incentive. It entices you to keep your money parked at the bank, so the bank can lend it out and earn a (higher) return for itself from other customers.
But let's say your bank didn't want you to sit on your cash; let's say your bank didn't care about profits and instead more cared about getting you to do something more beneficial for the economy. Bank of America isn't going to do that anytime soon, but a central bank might.
So a negative deposit rate would be a disincentive. By charging a negative interest rate, the ECB could inspire banks to do something with that reserve cash, instead of just holding it at the ECB.
It's not an entirely unprecedented move, either. Sweden and Denmark both experimented with negative interest on excess bank reserves in the wake of the financial crisis. But in both cases, it doesn't look like the policy actually made banks lend more.
In addition, negative interest rates could boost the European economy by lowering the value of the euro. That would boost EU exports and boost the union's economic growth.
Could the US try this?
It's not entirely out of the question. The Fed has been looking for ways to boost bank lending (and therefore the economy) for quite a while. In addition, James Bullard, president of the St. Louis Fed, has said the Fed should study the impact of negative deposit rates. So the idea has friends in high places. Currently, the deposit rate at the Fed is 0.25 percent.
That said, not everyone is convinced this would work. In a 2012 blog post, for example, economists at the New York Fed argued that the idea wouldn't really affect how much money banks hold on reserve at the Fed.