Are Negative Interest Rates The Answer to Economic Chaos?

The New York Stock Exchange’s daily chart looks like a schematic of some of the scariest roller coasters in the world. Up steeply one day, precipitous plunge the next, then a long slow climb back up, only to drop like a rock the next week. What are we, the average schleps on the street, gong to be facing? Something is up with that, because so many are discussing negative interest rates as the answer to economic chaos that no one admits even exits!

A goal at OutOfYourRut.com is to give you a better understanding of trends so you can ride long and safely through career and money issues. Sometimes we offer tips and techniques. This time we are going to explain a very complicated, once obscure, inclination in the banking and bond markets. “Negative Interest Rates” were once just casual conversation at dinner parties (OK, boring dinner parties 😉 ) but now they are the apparent trend du jour in the financial world.

Let’s Define “Negative Interest Rates”

Negative interest rates are intended to

  • Punish those with liquid cash to force them to withdraw it from the savings “food chain”
  • Promote more investments to excite the economy
  • Discourage certain investments not thought to be conducive to the overall good of the economy
  • Try to stabilize the economy
  • Lower a country’s currency value when it is rising because investors are looking for safer places to put their money
  • Encourage banks to stop hoarding money; this was the case in our own banking system in 2008 – the banks had the money but were not making loans because they were too risky.

Are Negative Interest Rates The Answer to Economic Chaos?
Are Negative Interest Rates The Answer to Economic Chaos?
Luke Malpass, writing in the “BusinessDay” column of the Sydney (Australia) Morning Herald on June 6, 2014, explained the concept:

”Negative interest rates are exactly what they sound like – depositing money actually attracts a charge rather than earning interest…The idea of this is that the banks will not deposit any more than necessary with [a central financial institution] and instead will lend the money, or invest in more profitable activities with a higher return.

What does this mean for bank customers? It depends on the bank. It might lower or charge its own negative interest rates, keep them the same and eat the loss, or charge interest indirectly through higher deposit fees.

The [Australian] Commonwealth Bank chief currency strategist Richard Grace estimates that there will be €124 billion [$138 billion] of excess liquidity (cash) as a result of the negative interest rates move. This gives banks three options: lending the money into the economy…parking it in interest-paying…bonds, or shuffling it into higher-yielding assets such as the Aussie dollar.”

The most visible reaction has been a lowering of the value of currencies in the countries where it is been done, most notably the European community. The potential of the trend becoming the norm is theoretical, since calculating the downsides is tricky and confusing.

America’s Federal Reserve Chair, Janet Yellen, acknowledged in a congressional hearing the week of February 8, 2016, that the Fed was looking at the strategy, but she was careful to emphasize no adoption of it was pending.

Do Negative Interest Rates Really Work as Promised?

No one knows. It looks good on paper but no nation has attempted it on a long term basis. The effects could be freakish with unplanned consequences, including the expectation banks will pass on to customers the costs they are hit with for depositing money.

Denmark introduced negative interest rates on a temporary basis. 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. It didn’t cause a financial meltdown, because the Danish central bank gave plenty of warning. Nor did it lead to a noticeable change in the interest rates charged by banks for bank loans.

Negative returns on leaving funds in a central bank could encourage money managers to invest in unsafe assets, possibly driving new asset bubbles and more pain further down the line. But then driving asset bubbles seem to a primary aim of central banks these days, so it would hardly be out of character.

As another way to find alternative investments, institutions might increase their purchases of government bonds. However, this has 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.

New York Times financial columnist Neil Irwin talked about this trend on February 12.

”But don’t people just withdraw cash rather than pay to deposit it at their bank or buy a government bond that will give them back less than they paid?

You’d think, right? This was exactly why economists had long thought that negative interest rates were impossible. It helps explain why central banks first turned to other tools, including quantitative easing, when they saw a need to ease monetary policy despite interest rates that were already near zero.

But it looks as if the convenience of keeping money in a bank account is worth a small negative interest rate or fees for most consumers and businesses, at least at the only slightly negative rates currently in place. Storing and providing security for cash may be more expensive than a small bank charge.

When initial experiments in Switzerland and Sweden didn’t result in mass withdrawals from the banking system, larger central banks in need of easier money moved gingerly in the same direction. They’ll stop when either their economies start to grow or they see more concrete evidence that negative rates are doing more harm than good.”

These steps are not unusual in world economies. Central banks have always manipulated interest rates, governments have adjusted import and export tariffs, and industries attuned price to favor themselves in competitive situations. All these techniques are intended to improve cash flow and make investment more favorable. Favorable investing means better jobs outlooks and a positive trade deficit.

Since It Ain’t Broke, Why Fix It? Is It The Right Solution?

Jana Randow and Simon Kennedy, writing on Boombergview.com in January of this year, aren’t enthusiastic.

”Negative interest rates are a sign of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans to businesses or to weaker lenders. Rates below zero have never been used before in an economy as large as the euro area. While it’s still too early to tell if they will work, Draghi said in January 2016 that there are “no limits” on what he will do to meet his mandate. Europe’s central bank chose to experiment with negative rates before turning to a bond-buying program like those used in the U.S. and Japan. Policy makers in both Europe and Japan are trying to prevent a slide into deflation, or a spiral of falling prices that could derail the economic recovery. The euro zone is also grappling with a shortage of credit and unemployment near its highest level since the currency bloc was formed in 1999.”

Irwin outlines these negatives about the policy:

”The global financial system is built on an assumption of above-zero interest rates. Going below zero could cause damage to the very architecture by which money and credit zoom through the economy, and in turn inhibit growth.

Banks could cease to be viable businesses, eliminating a key way that money is channeled from savers to productive investments. Money market mutual funds, widely used in the United States, could well cease to exist. Insurance companies and pension funds could face their own major strains.”

Trying to boil all this down, it seems the trend will not significantly improve the volatile nature of world economies until there are major shifts in traditional ways of doing business. Exporters are quite content with it because is lowers the value of nation’s currency against the rest of the world, making their exports more valuable. Its wide-spread use could well destabilize the banking system since those institutions would no longer be the first destinations for people wishing to save money and get even a modest return on their investment.

In a speech last year, Hervé Hannoun, then the deputy general manager of the Bank for International Settlements, even argued that this could “over time encourage the use of alternative virtual currencies, undermining the foundations of the financial system as we know it today.” (Bit coin investors, are you listening?)

Will It Happen Here?

Fed Chair Yellen doesn’t think so, but in two days of congressional testimony, she also didn’t rule it out. Here are her reasons why:

  • The US economy and its labor market looks to be in stronger shape than that of many others around the world.
  • The fed expects to be in interest-rate raising mode this year (though exactly how fast is very much in question).
  • There is a question of whether it would even be legal. It’s not clear if the language of the Federal Reserve Act allows negative bank rates. Ms. Yellen said in testimony this week that the legality of negative interest rates “remains a question that we still would need to investigate more thoroughly.”
  • She also said “it’s also a question of could the plumbing of the payment system in the United States handle it? Is our institutional structure of our money markets compatible with it? We’ve not determined that.”
  • Ms. Yellen noted that the rates on treasury bills could go negative even in the absence of a policy shift by the fed, as has happened a few times in the past.

And this might be the major tip-off that the practice is not likely to come to America: In its annual “stress test” for major banks, the fed asked what would happen to their finances in a “severely adverse” scenario that included a sharp rise in unemployment and a rate of negative 0.5 percent on short-term treasury bills — in other words, what you’d expect to see if there were a recession and the fed cut rates well below zero.

So what are some of the weird things that could happen in a world in which negative rates become routine? Neil Irwin suggests

”For example, would people start prepaying years’ worth of cable bills to avoid having money tied up in a money-losing bank account? How about property taxes? Would companies and governments put in place new policies prohibiting people from paying their bills too early?

Or consider this: many commercial transactions now take place with some short-term credit attached — for example, a company that gets a 60-day grace period to pay bills from its suppliers. Would that flip, and suddenly suppliers would prohibit upfront payment and insist that their customers wait 60 days to pay?

Might new businesses sprout up that allow people to securely store thousands of dollars in bundles of $100 bills, or could people buy physical objects as stores of value that the banks can’t charge a negative interest rate on?”

“Negative interest rates in Japan is blowing my mind,” said Jose Canseco, the provocative retired baseball player not normally known for his economic musings, on Twitter. And the truth is, he’s not the only one.

What do you think? Would negative interest rates be a viable alternative in a major economic crisis in the United States? Do you believe it would adversely affect your personal life style? Have you even heard of this trend?

( Photo by AndyRobertsPhotos )

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