Interest rates are rising in the US, but in other places they’re still below zero — here’s what that means

Samantha Lee / Business Insider

It’s only the second time in a decade. On Wednesday, the Federal Reserve hiked its benchmark interest rate by a quarter of a percent to the range of 0.5% to 0.75%. That number doesn’t affect most Americans directly. It’s a target for the rate charged when banks lend money to each other overnight.

But it eventually filters through the economy, so when the Fed increases rates, it means mortgages will be more expensive, savings accounts will be more lucrative, and student loans a tiny bit more painful.

Fed Chair Janet Yellen cited the “considerable progress the economy has made” in the Federal Reserve Board’s decision to increase the rate. But historically speaking, 0.75% is still incredibly low. Rates in the US have been hovering near-zero since the financial crisis nearly a decade ago.

It’s been worse in Japan and Europe. Japan’s economy has been weak for so long that it still has negative rates — it actually charges banks to hold money — a once unheard of phenomenon. The European Central Bank’s benchmark rate is also negative, reflecting the slowdown on the continent. In fact, negative rates were so unheard of until recently, academics had to rewrite their textbooks.

Why go negative anyway?

If you’re a bank, the idea sounds crazy. Why pay someone to hold your cash?

In 1983, when Frederic Mishkin started writing “The Economics of Money, Banking and Financial Markets,” his seminal textbook on macroeconomics, he never thought he’d devote much space to the idea of negative interest rates.

“A million years no,” Mishkin told Business Insider.

Negative rates were seen as a bizarre thought exercise by academic economists, not something any of us would see in the real world.

It was “absolutely unthinkable when I started writing this book,” Mishkin, a former Federal Reserve governor and professor at Columbia Business School, said.

In fact, it took just about 30 years. And as Mishkin finishes the 12th edition of his textbook, he’s devoting a whole lot of space to negative interest rates.

“There’s something very shocking about this,” Mishkin said. “I have to talk about how negative rates are something that can be very prevalent.”

At a basic level, a negative interest rate occurs when a lender pays someone to borrow its money.

The policy has evolved from radical idea to mainstream policy of postrecession governments in Europe and Asia. And in the past, Janet Yellen has said the US will not rule out using them if it needs to.

This is because the Great Recession has rewritten the rules of what can happen — and how central banks can respond — during financial crises. Negative rates could affect just about everyone, notably businesses, banks, homeowners, and anyone with a savings account.

The old way

The US Federal Reserve in Washington, DC.

Centrals banks, like the Federal Reserve in the US or the Bank of England in the UK, control a country’s supply of money and set the interest rates that apply when a bank lends to another bank, usually to meet mandates for how much each bank has to keep in reserve.

And for much of the past century, our economic system has worked something like this:

You earn money through your job. You deposit some of that money in your bank. The bank takes a portion and lends it out to customers and stores some of the rest at the Federal Reserve. If it has more at the Fed than is required by regulation, it lends the extra to other banks, which might not have enough in reserve. That’s called interbanking lending, and the interest rate we’re talking about when we talk about the Fed changing rates applies to that lending between banks overnight. This is actually the most important rate in the country. All other major interest rates are based on it, at least indirectly.

Changing this rate is a kind of lever that the Federal Reserve can pull to make things happen in the economy. If it wants to spur banks to lend, which should boost the economy, it lowers the rate. That eventually makes mortgages and car loans more affordable for consumers. If it wants to slow a raging economy, it raises interest rates.

And for most of our modern financial history it was inflation — the increase in prices — that kept central bankers up at night. As Kenneth Rogoff, an economics professor at Harvard, recently told Business Insider, when he was studying economics in the late 1970s, “Everyone said we’d never grow fast again. Inflation was double digits.

“If you had told me we’d be in some future where central banks were struggling to get inflation up from zero or 1% and they wanted it to be a little higher, I’d say we’re living in an alternative universe.”

Breaking through the floor

Interest rates shattered the 0% floor in some countries since the Recession.Samantha Lee / Business Insider

When the Great Recession hit in the late 2000s, central banks did all they could to ease the pain. They lowered interest rates rapidly, a traditional strategy for shoring up free-falling economies. In many places, rates hit zero. When that didn’t do enough, some central banks, such as the Federal Reserve, tried nonstandard ways to boost the economy. The Fed started buying back its own bonds with newly created cash — what’s known as quantitative easing, or QE.

But there was still one thing that seemed unlikely: going negative. In textbooks like Mishkin’s, a 0% interest rate was known as the “zero lower bound.” It just didn’t seem to make sense to go below that.

Now economists have to rename it.

When QE and a zero interest rate weren’t enough in some parts of the world, like Europe and Japan, central bankers did the unthinkable. They started to set interest rates slightly negative.

“You don’t do this on a normal sunny day,” Rogoff said.

What this means, in practice, is that banks that have money to spare would pay to lend it out. The other bank would actually get paid to take on debt.

So far, Sweden, Denmark, Switzerland, and Japan have tried negative rates with varying levels of success. Sweden’s Riksbank was first, in 2009, to take rates below zero. Central banks in Denmark, Switzerland, and the European Central Bank (ECB) eventually followed.

In an important 2012 speech, ECB President Mario Draghi said Europe’s central bank would do “whatever it takes” to save the euro. Inflation was too low, and borrowing costs in Spain and Italy were getting out of hand — so high that Spain was about to ask for a bailout.

Today, countries with negative policy rates make up almost a quarter of global gross domestic product, according to the World Bank.

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Watch Ken Rogoff explain negative interest rates: