As described here, the plan for paying interest on reserves is somewhat complicated, with three tiers of reserves and different interest rates applied to each. Paraphrasing, interest will be paid at 0% on required reserves, at 0.1% on a reference level of reserves (a bank's average excess reserve balance during 2015), and at -0.1% on anything in excess of the sum of those two quantities. The effect of this will depend on how reserves are distributed in the financial system. For some banks the marginal unit of reserves will earn -0.1%, and for some banks the marginal unit will earn zero or 0.1%.
Why can nominal interest rates be negative? In most mainstream monetary models there is in fact a lower bound of zero on the nominal interest rate. Why? For example, in a standard New Keynesian (NK) "cashless" model, people hold zero money balances in equilibrium, and all other safe assets, including government debt, bear interest. If the nominal interest rate on all of those safe assets were negative, then people could borrow at the safe rate of interest (in baseline NK models there is no default), hold cash, and make a profit. Arbitrage then dictates that the nominal interest rate cannot fall below zero. In practice, the nominal interest rate on currency is always zero, so if it were costless to hold currency and to convert it into reserves and vice-versa, then if banks faced a negative interest rate on reserve balances they would always prefer to hold currency rather than reserve balances. The reason that the interest rate on reserves can be negative is that it is not costless to hold currency, nor is it costless to convert reserves into currency, or vice-versa. Currency can be stolen, and it takes up physical space, which makes it extremely inconvenient for large interbank transactions. For a bank in the United States, converting currency into reserve balances means putting the currency in a truck and taking it to the local Federal Reserve Bank (or one of its branches), which of course uses up time and resources.
There is nothing new about negative interest on reserve balances - some central banks, including the Swiss National Bank, the Central Bank of Denmark, the Swedish Central Bank, and the ECB, have been doing this for some time. Further, negative nominal interest rates have been discussed extensively by economists. Some people like the idea, including Ken Rogoff and Miles Kimball, and have devised schemes that would in principle allow central banks to violate the zero lower bound in a big way. That is, at some sufficiently low negative nominal interest rate, arbitrage profits must overcome the costs of holding currency, and the nominal interest rate can't go any lower. But what if central banks did away with currency, or imposed extra costs on holding it? That would give them plenty of leeway on the south side of zero.
So, central banks can set interest rates on reserves below zero, and in so doing can put overnight market interest rates in negative territory as well. But why do they contemplate such a thing, and implement negative interest rate policies? Stefan Ingves, the Governor of the Swedish Riksbank, explains it here:
GDP growth is fairly good and the labour market is strengthening gradually, but inflation is too low in relation to the Riksbank's target for inflation. In recent months, inflation has begun to rise and the repo rate needs to be this low so we can be sure that inflation will continue to rise and attain the target.And:
A repo rate just below zero gives a further boost to household consumption and company investment. Together with the repo-rate cuts we have made earlier, this gives higher inflation in the long run and higher interest rates, which will also benefit all savers. It will take us back to a more normal situation in the Swedish economy and this will be good for us all.He's saying that, in terms of the Riksbank's goals, things are going well, except that inflation is running below the Riksbank's 2% inflation target. The Governor hopes for a future world in which inflation and nominal interest rates are higher. So, you might ask, why doesn't he just increase nominal interest rates, and allow the Fisher effect to produce higher inflation? No, he says, the way to do it is - here we have to read between the lines - to reduce the nominal interest rate below zero, stimulate real activity, and then the Phillips curve will produce the inflation that the Governor can then tamp down by increasing the nominal interest rate. Then we're back to normal.
So, how has that strategy been working? This is the overnight repo rate in Sweden, along with the Riksbank's forecast of where it's going:
Some people have made a big deal of what they see as a policy mistake by the Swedish central bank - the interest rate hikes you see in the first chart beginning in 2010 which were subsequently undone. We could quibble about whether the Bank did the appropriate thing in 2010 - though I tend to agree with Marvin Goodfriend and Mervyn King that the Riksbank's 2010 tightening was well within the bounds of normal central bank behavior. However, what has happened post-2013 seems like a more obvious failure - the Riksbank has been pursuing a policy which isn't paying off as they say it will. Inflation remains persistently below the 2% target.
What about the other countries with central banks that have gone negative? Here's the overnight interest rate and the CPI inflation rate in Switzerland: As I show here, lowering the nominal interest rate below zero just makes inflation lower.
So, if the theory - neo-Fisherian theory - is so obvious, and given the experience we have already had with negative nominal rates, why does the Bank of Japan think that its new program will increase inflation? For a very long time, a Phillips curve theory of inflation was what central bankers believed, and in some countries those central bankers were successful in keeping inflation low, but not too low (assuming a 2% inflation target, say). This worked for the Fed, for example, during the Great Moderation period - parts of that episode look like the Fed had adopted a 2% inflation target, and was succeeding. Central bankers would cut rates in a recession, and then increase rates in the recovery. Even if inflation was not actually increasing in the recovery phase, central bankers could argue that a tighter labor market would surely increase inflation in the future. A typical argument was that, in the recovery phase, tightening needed to occur sooner rather than later, particularly given "long and variable lags," etc. As John Cochrane says, they could then pat themselves on the back for controlling the inflation which they had themselves created.
But that doesn't work if central bankers don't get the timing right. If they wait too long to increase interest rates in the recovery phase, low inflation sets in, along with doubts about the wisdom of "tightening." Doubts give way to panic, which leads to lower and lower interest rates, and various experiments with unconventional polices - QE and nominal rates below zero. The Phillips curve was sometimes a convenient fiction, but in this instance it's a curse - believe in it and you're in trouble.
So, what to do? Central banks, and many economists, won't declare the Phillips curve dead. The parrot is motionless at the bottom of the cage, but perhaps he's only pining for the fjords? Some, like Olivier Blanchard, are at least willing to concede that the parrot appears quite lethargic. But, religious conviction is very hard to overcome. One approach is to put religion aside, and show people that, even in models they like to use - models including Phillips curves - neo-Fisherian results hold, i.e. increases in nominal interest rates by the central bank make inflation go up. So, people can abide by their religious beliefs, but we are all neo-Fisherians. Mike Woodford is a neo-Fisherian, Knut Wicksell (and by implication Paul Krugman) was a neo-Fisherian. So, is Narayana Kocherlakota, though he's trying hard to deny it.
So, for central bankers currently seeing low inflation and wondering what to do, take the express route. There's no need to resort to a process of elimination. Most of the supposed solutions for low inflation - QE, negative nominal interest interest rates - have been tried, and haven't worked. Be neo-Fisherites. You'll sleep much better.