What Happens if Interest Rates Go To Zero?

Can interest rates go to zero? Could they even be negative? I've heard that this has happened before. What would cause something like that to happen and what impact would it have on the economy?

A: Great questions!

First we need to distinguish between nominal and real interest rates. The article What's the difference between nominal and real? The quick answer is that nominal interest rates are the ones you typically hear about (prime rate, etc.) whereas real interest rates factor out inflation.

This week we will examine zero nominal interest rates. Next week we will look at zero real interest rates.

Zero Nominal Interest Rates

A zero nominal interest rate occurs when the interest rate is the same as the inflation rate. If inflation is 4% then interest rates are 4%. If you lent or borrowed for a year at a zero real interest rate, you would be exactly back where you started at the end of the year. I loan $100 to someone, I get back $104, but now what cost $100 before costs $104 now, so I'm no better off.

Typically nominal interest rates are positive, so people have some incentive to lend money. During a recession, however, central banks tend to lower nominal interest rates in order to spur investment in machinery, land, factories, etc. If they cut interest rates too quickly, they can start to approach the level of inflation. Inflation will often rise when interest rates are cut, since these cuts have a stimulative effect on the economy.

According to some economists a zero nominal interest rate can be caused by a liquidity trap:

"The Liquidity trap is a Keynesian idea. When expected returns from investments in securities or real plant and equipment are low, investment falls, a recession begins, and cash holdings in banks rise. People and businesses then continue to hold cash because they expect spending and investment to be low. This is a self-fulfilling trap."

There is a way we can avoid the liquidity trap and, for real interest rates to be negative, even if nominal interest rates are still positive. It occurs if investors believe a currency will rise in the future. Suppose the nominal interest rate on a bond in Norway is 4%, but inflation in that country is 6%. That sounds like a bad deal for a Norwegian investor because by buying the bond their future real purchasing power would decline. However, if I'm an American investor and I think the Norwegian krone is going to increase 10% over the U.S. dollar, then buying these bonds is a good deal. If I'm right about the currency jump, then I'll gain 10% from switching from the U.S. dollar to Norwegian krone denominated bonds today. On top of that, I'll also receive the 4% gain in interest.

As you might expect this is more of a theoretic possibility than something than occurs regularly in the real world. However, it did take place in Switzerland in the late 1970s, where investors bought negative nominal interest rate bonds because of the strength of the Swiss franc.

I hope this answers your question about negative real interest rates. In What Happens if Nominal Interest Rates Go To Zero? we examine the case of negative nominal interest rates. If you have a question about interest rates, please contact us, by using the