Today's Headlines: The Grand Experiment Of Negative Interest Rates

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Today's Headlines: The Grand Experiment Of Negative Interest Rates
February 16, 2016

Why Go Negative?

Imagine a notice from your bank saying that instead of paying interest on your deposits, from now on they’re going to charge you for the privilege of keeping money at their bank — effectively a negative interest rate. Why would you keep money in that bank at all? You would do better stuffing your money under the mattress, or, more realistically, in a home safe.

For two prominent Central Banks, negative interest rates are now a reality. The European Central Bank and Bank of Japan have both entered negative interest rate territory, where they charge banks to hold their money. Federal Reserve Chairman Janet Yellen testified on Capitol Hill that she does not expect interest rates to go negative in the US, and there is some question as to whether the Fed could legally charge negative rates, but she declined to rule out the idea.

Why would banks charge negative interest rates? In theory, interest rate decreases spur economic growth by giving banks disincentive to hang onto cash and greater incentive to increase lending via lower borrowing costs. More money enters into the economy, businesses expand, and growth follows. Some economists assume that logic follows even when such a drop makes interest rates negative. That assumption is being challenged by stock market results across the world.

Negative Rates, Negative Results...So Far

According to a Wall Street Journal blog, Central Banks with negative interest rates set the policies for countries that total over 20% of the world's gross domestic product (GDP).

Since the European Central Bank entered negative rate territory in June 2014, the iShares MSCI EMU Index ETF that tracks Eurozone mid- and large cap companies is down 30%. Similar results have been found in Switzerland and Sweden. Japan just entered negative interest rate territory on January 29, with the Nikkei reacting poorly in the short term. Denmark is the only country where stocks have gained under negative interest rates.

In fairness, it takes time to evaluate the effect of negative interest rates on stocks, especially because there is little history to consult. It is possible that the concept of negative rates is so foreign to average investors that they are seen as acts of desperation, and thus they produce further uncertainty instead of reassurance.

How Low Can We Go?

Some argue that size of the interest rate decrease is the important variable to spur growth. According to Larry Summers, a former Treasury Secretary, "History suggests that when recession comes it is necessary to cut rates by more than 300 basis points [3%]." The Fed followed through in 2007, cutting rates from 5.25% in mid 2007 to effectively zero at the end of 2008, helping to blunt what could have become a depression.

If another recession follows, would central banks consider making a similar drop and send interest rates to -3% or even lower? How could banks survive in such an environment? There logically must be an inflection point where negative rates are so low that banks cannot find clever ways to pass the costs on to depositors through fees (or passing on negative rates directly to investors). Would alternative currencies flourish?

Another concern about larger negative interest rates is the effect on money market funds. This major source of liquidity for both businesses and governments would be severely squeezed. What alternatives to liquidity could become available? It is a fascinating world of possibilities that most banks and economists really do not want to explore in real life.

It's Different on the Other Side of Zero

If central banks are hesitant to dip far into negative rate territory, what options do they have to mitigate a recession when interest rates are near zero or sub-zero? Stimulus such as quantitative easing (central banking purchasing of securities to inject new money into the money supply) can help, but it does so at the expense of racking up a huge balance sheet. The Fed currently holds a staggering 2.46 trillion in Treasury securities, around 5 times the amount it held at the beginning of 2009. Pumping money into the system arguably saved us from depression, but the amount of return we received is limited.

Essentially, that money is dispersed unevenly throughout the system, only slowly trickling through to consumers who hold the key to driving the economy. Central banks can make interest rates as low as they want, but without demand or reason to expect demand in the relative short-term, businesses are not going to invest their money. They will sit on it instead, waiting for demand to rise.

Dropping interest rates even further into negative territory squeezes banks in both directions. Eventually, depositors will seek alternatives for saving their money. Banks will be unable to pass along further interest rate drops to their borrowers without risking insolvency.

In essence, there is only so much that central banks can do in the absence of positive interest rates and proper government actions. Central banks cannot easily target their stimulus. Governments can, and do. Unfortunately, they do not always target wisely.

Money to the People!

The Obama administration's stimulus to stave off recession was supposedly targeted toward "shovel-ready" jobs, but the simple truth is that today's government has a hard time creating such jobs thanks to regulatory hurdles and other roadblocks.

Economist Milton Friedman introduced the concept of "helicopter money", arguing that central banks could prevent deflation simply by dropping money out of helicopters directly to the people as a last resort. Don’t expect that anytime soon, but the principle of ensuring that stimulus gets to the people is sound. The Australian government did so in 2008, pumping $10.4 billion in directed funds supporting the housing market, pensioners, and support payments for families. As a result, interest rates there have found a relatively stable floor at 2%.

The point: negative rates alone cannot stimulate an economy, and there are serious concerns that unintended consequences of negative rates could scuttle the slowly growing economy that we do have. Rates may be less important than the mechanisms of getting money to consumers via combinations of job creation and direct stimulus.

The Takeaway

We believe negative interest rates are unlikely in the US. Should they occur, the unpredictable psychology of the market would determine the next move. The best advice in such a scenario is to stick to your current portfolio plan, possibly edging it toward conservative stocks. Stocks are more volatile than the economy right now, and your best bet is to ignore the daily panics and stick with your long-term investment plan. Should negative interest rates actually occur, re-evaluate at that time instead of trying to anticipate a purely unpredictable response.

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Erin | 02.16.16 @ 18:05
I can't imagine paying a bank to keep my money. That's their one job! I don't even understand why some of them make you keep a minimum balance. Good advice to reevaluate if/when it becomes a reality.
Jo Ann | 02.16.16 @ 18:05
Useful information to watch for in these uncertain times. The negative interest rates could really hurt our economy , unless the stimulus is given directly to people instead of corporations. People buy when they have money fortunately.
Elaine | 02.16.16 @ 18:05
This article makes me uneasy. The talk makes me nervous on what is actually the truth and what exactly will work.
Carla | 02.16.16 @ 18:05
From the sound of the overseas experiment, I hope it doesn't happen here.
Nancy | 02.16.16 @ 18:06
I never even realized that a negative interest rate was possible, much less that would even be considered.
Chrisitna | 02.16.16 @ 18:07
Getting charged for keeping money in a bank (negative interest) is going to just encourage people to pull their money out of banks and cause further issues. I like the idea of helicopter money ;).
irene | 02.16.16 @ 18:08
Our bank recently started charging if we don't keep enough money in our account!
Steffanie | 02.16.16 @ 18:09
I truly hope we do not see this here. Doesnt sound good at all....
$commenter.renderDisplayableName() | 11.29.20 @ 20:23