Last December, Bank of Canada governor Stephen Poloz gave a talk at the Empire Club of Canada in which he discussed four so-called unconventional monetary policies to desperately help stimulate the Canadian economy.

Japan Economy

Governor of the Bank of Japan Haruhiko Kuroda arrives at their head office in Tokyo Friday. The Bank of Japan has introduced a negative interest policy in a move to boost the stumbling recovery of the world's third-largest economy. (Kyodo News via The Associated Press)


The most striking of these policies was to lower the central bank interest rate below zero. Yes, that's right: negative interest rates! The idea is being increasingly discussed around the world, although it has surprisingly not been prominent in the mainstream media yet. But before you jump for joy and think your mortgage rate will suddenly become negative, know that this is probably not going to affect you in any way.

Negative interest rates are a relatively new policy. There are a few places where central banks have already implemented them, such as Switzerland and Denmark. On Jan. 28, the Bank of Japan announced it lowered its rate below 0.

This is certainly not good news, but a continued sign of our inability to stimulate domestic economies in the absence of fiscal policy. In Canada, forecasts about growth in 2016 continue to be revised downward, despite the Bank of Canada's sunnier prediction.

Negative interest rates: how they work

But what are negative interest rates? What do they mean and how do they work?

To better understand the importance of negative rates, two important issues must be discussed. First, monetary policy has in a way exhausted its ability to stimulate the economy because of what economists call the "zero lower bound."

BoC Interest Rate 20150715

Bank of Canada Governor Stephen Poloz responds to a question on the banks interest rate cut decision during a news conference in Ottawa, Wednesday July 15, 2015. (Photo: THE CANADIAN PRESS/Adrian Wyld) (Adrian Wyld/Canadian Press)

In normal times, interest rates cannot be forced below zero. But as we all know now, these are not normal times: the Canadian economy is going through its worst performance since the Great Depression, and the economy has not recovered from the 2007 crisis.  After having fallen back into recession in the first part of 2015, prospects for 2016 and 2017 are bleak (and another recession has not been ruled out.)

In other words, at such low rates, monetary policy becomes largely ineffective because the central bank is running out of room to lower rates. This then brings us to our second point: central banks, and the Bank of Canada in particular, believe the rate of interest that would effectively bring the economy back to full employment is in fact negative — what economists call the natural rate. 

In other words, even at 0.5 per cent, rates are still too high.

Setting lower bar

Mr. Poloz has said "the effective lower bound for Canada's policy rate is around minus 0.5 per cent, but it could be a little higher or lower." If rates were closer to that mark, the thinking is that the economy would pick up.

In theory, of course, nothing prevents the Bank of Canada from setting its rate at minus one per cent and some commentators have said this will likely happen in 2016.

How then would negative rates work? Essentially, the Bank of Canada offers interest on the deposits of the commercial banks at the central bank, just like commercial banks offer us interest on our deposits with them. With negative rates, commercial banks would now have to pay the central bank to hold deposits with them. By charging interest on bank deposits, the central bank is hoping banks will want to avoid paying interest and instead start lending out their excess funds again, and thus spur the economy back to full employment.

Will negative rates work?

Sadly, they won't. They are based on a faulty understanding of our banking system. The reason banks do not lend is not because they are constrained by liquidity, but because they are unwilling to lend in such uncertain times.

Banks lend in the hope of getting reimbursed with interest. But banks are too pessimistic about the ability of the private sector to honour their debt, and so prefer not to lend. Having extra cash courtesy of the central bank imposing negative rates won't change the dark economic narrative.

Is it possible negative rates will help consumers? Again, probably not. For consumers to benefit, banks must pass on these negative rates to borrowers. As we have seen with respect to the last two rate decreases, banks have been unwilling to pass through the full effect of the decreases and will continue to resist. It is possible that by lowering rates to zero or below, banks will pass only a tiny portion of this to borrowers.

In the end, I hate to sound like a broken record, but monetary policy has been largely useless. What we need now is significant fiscal stimulus, precisely what John Maynard Keynes prescribed. Will governments finally listen?

Louis-Philippe Rochon is an associate professor at Laurentian University and co-editor of the Review of Keynesian Economics.


  • This commentary initially reported that Bank of Canada Governor Stephen Poloz "believes that the rate that would stimulate our economy is somewhere near minus one per cent." In a speech on Dec. 8, 2015, Poloz actually said, "We now believe that the effective lower bound for Canada's policy rate is around minus 0.5 per cent, but it could be a little higher or lower."
    Feb 02, 2016 5:30 PM CT