Daniel L. Thornton

English

Research Papers in Economics

January 1999
MonetaryTrends
Nominal Interest Rates:
Less Than Zero?
Can nominal interest rates be less than zero?  Many
people would argue not, reasoning that no one would
invest $100 today with a promise of receiving only, say,
$99 in one year, given the alternative of simply holding
the $100 in cash.  Yet, rates on short-term Japanese
government bills recently were negative, and several for-
eign-owned banks in Japan have paid negative nominal
interest rates on yen deposits.
Is there a paradox?  Not really.  The claim that the
nominal interest rate cannot be negative assumes that
holding currency is costless.  In the real world, however,
holding cash is risky and costly.  Like any valuable, cash
can be lost, stolen or destroyed.  Just as people pay
depositories a fee for safekeeping other valuables, indi-
viduals are willing to pay a fee on deposits rather than
bear the risk associated with holding cash.
In addition, there are costs associated with moving
and storing cash.  While these costs are trivial for a small
amount of currency, they are not for large amounts.
Consequently, individuals may prefer to maintain
deposits at banks or hold Treasury bills rather than trans-
port and store cash, even when these assets have negative
rates of return.  In effect, the negative nominal return rep-
resents a fee that individuals pay to hold deposits or
Treasury bills rather than bear the risks and costs of hold-
ing cash.  Just how negative the nominal interest rate can
become depends on the willingness of individuals to pay
for the risks and the costs associated with holding cash.   
Deposit rates typically are lower than other rates for
several reasons.  Fundamentally, banks and other finan-
cial intermediaries profit by borrowing funds (taking
deposits) at one rate and re-lending those funds at a high-
er rate.  Depositors are willing to lend their funds to
intermediaries rather than make the investments them-
selves because intermediaries are specialists at assessing
and diversifying risk￿something that is particularly dif-
ficult and expensive for those with small amounts to
invest.  In addition, deposits offer advantages over hold-
ing cash or other investments.  For example, checks or
electronic transfers from deposit accounts are more con-
venient and less costly, especially for large payments or
payments to distant points.  Furthermore, banks often
bundle services, so deposit holders may gain access to
certain bank services or to better prices on those services
than nondepositors.
Finally, deposit rates usually are lower than other mar-
ket rates because deposits bear less risk of default.  This
is certainly the case when the government guarantees
deposits.  Perceptions of default risk now are reflected in
deposit rates at domestic- and foreign-owned banks in
Japan.  Deposit rates at foreign-owned banks generally
have been lower than those at domestic banks because
depositors view Japanese banks as riskier.
When market rates are very low, as they are in Japan
today, deposit rates are correspondingly low, maybe even
negative, because banks are unwilling to pay depositors
high rates when the expected return on loans and other
investments is low.  Other things the same, individuals
are willing to accept low nominal returns on deposits
because they are paying for services that banks provide.
Investors are willing to accept a negative nominal return
on a risk-free asset because holding it is cheaper and less
risky than transporting and storing cash.
￿Daniel L. Thornton
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Nominal interest rates: less than zero?

http://research.stlouisfed.org/publications/mt/19990101/cover.pdf

Nominal interest rates: less than zero?

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