What are negative interest rates?

BREAKING DOWN 'Negative Interest Rate Policy (NIRP)'

During deflationary periods, people and businesses hoard money instead of spending and investing. The result is a collapse in aggregate demand which leads to prices falling even farther, a slowdown or halt in real production and output, and an increase in unemployment. A loose or expansionary monetary policy is usually employed to deal with such economic stagnation. However, if deflationary forces are strong enough, simply cutting the central bank's interest rate to zero may not be sufficient to stimulate borrowing and lending.

A negative interest rate means the central bank and perhaps private banks will charge negative interest: instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe.

Many economists expect the ECB to cut its deposit rate to -0.1% on Thursday and the hope is that this will encourage the banks to stop hoarding money. Photograph: Daniel Roland/AFP/Getty Images
The European Central Bank and its president Mario Draghi are expected to announce measures on Thursday to breathe life into the struggling eurozone economy and head off the threat of deflation. One of the options for further stimulus is a cut in the interest rate banks receive when they deposit money with the ECB. The deposit rate is currently zero, so any reduction would take it into negative territory.

How do negative interest rates work?

Instead of earning interest on money left with the ECB, banks are charged by the central bank to park their cash with it. Many economists expect the ECB to cut its deposit rate to -0.1% on Thursday and the hope is that this will encourage the banks to stop hoarding money, and instead lend more to each other, to consumers, and to businesses, in turn boosting the broader economy.

How likely is this?

It is a very strong possibility. Draghi is a master at carefully choosing his words to manage market expectations and at the May policy meeting he said he was "comfortable" with the idea of taking action in June. There is no guarantee that action will include a cut in the deposit rate, but after a reduction in the main interest rate (from 0.25% to 0.15% or 0.10%), it is seen as the most likely option.

Will it work?

No one knows. In theory it sounds attractive but it has never been attempted by the eurozone and could have unpredictable and unintended consequences. Those consequences include the possibility that banks will pass on to customers the costs they incur for depositing money with the ECB.

A broad risk is that a negative return on parking funds with the central bank might encourage banks to invest in riskier assets to secure a return, potentially driving new asset bubbles and more pain further down the line.

As part of this bid to find alternative investments, banks are likely to increase their purchases of government bonds. However, this has potentially serious consequences if banks are holding bonds to such an extent that government borrowing costs are artificially low. If a financial shock occurs, the banks and governments could find themselves so intertwined and interdependent that they drag each other - and the economy - down.

Has it happened before?

Sweden and Denmark have introduced negative deposit rates on a temporary basis in recent years. In Denmark, the aim was to cap an unwanted rise in its currency, which was pushed higher when foreign money flooded into the country as investors looked for safe havens outside the crisis-ridden eurozone. The move to negative deposit rates did not cause financial meltdown, with the Danish central bank issuing plenty of advance warning. Nor did it lead to a noticeable change in the interest rates charged by banks for bank loans. But then again negative deposit rates have never been tried by an economy on the scale of the eurozone, and the fear is that the Danish example will have little read-through for the 18-member bloc.

What would it mean for me?

Very little in terms of the detail of the policy and any impact on retail banking rates. However, if it provided the desired boost to the eurozone economy and put it on the path to a sustainable recovery, that would be good news for the UK economy too. On the flipside, if there were some nasty unintended consequences, including a shock to the eurozone banking system, Britain's economic recovery could potentially be undermined.