The Consequences of Negative Interest Rates

The Consequences of Negative Interest Rates

Ever since the crisis of 2008 the Fed had been utilizing what’s been called “quantitative easing” to focus on commercial banks to stimulate the economy. This approach involved purchasing a significant volume of bonds to drive up bond prices and reduce interest rates, with the expectation that the lower rates would stimulate demand for more borrowing and consequently more liquidity flowing throughout the economy.

But a funny thing happened. The banks sat on their reserves instead, demonstrating an unwillingness to lend at the level needed to pump up economic growth.  As a result, it took quite a few years before the U.S. economy managed to pull itself out of the hole created by the credit crisis.

In retrospect, the idea of pump-priming through increased liquidity appears to have made good sense. That’s because we had the opportunity to observe the result of the opposite approach at the same time.  In Europe, the central bank initially tried austerity to get the economy back on its feet.  That turned out to be such a mistake that the ECB has not only reversed course and embraced stimulation, they’ve now gone so far (together with Japan, Sweden, Denmark, and Switzerland) as to drop short term interest rates to below zero.  Right now there are more than $7 trillion of government bonds worldwide with negative yields.  This is an unorthodox approach that could further distort markets or alternatively become a new tool for monetary policy.  What are the consequences of such a move?

The idea is pretty simple. If the government charges banks to hold reserves, it provides a strong incentive for the banks to lend out those reserves (subject of course to minimum reserve requirements). And negative interest rates should reduce borrowing costs for companies and households, driving increased demand for loans.  In practice, though, it puts the banks between the proverbial rock and hard place.  Banks make a large portion of their profit on the spread between their lending and their deposit rates.  If they drop deposit rates below zero, depositors might stash their cash elsewhere, robbing lenders of a crucial source of funding. But if the banks themselves were to absorb the cost of the negative rates, their profit margins would become squeezed.  That might make them even less willing to lend.

On the flip side, imagine if you had a mortgage with a negative interest rate. The longer it takes you to pay, the less you owe.  In a world of negative consumer interest rates it would make more sense to borrow as much as you can and save as little as possible.  That, however, would be a dangerous way to manage your long-term finances.  Fortunately you are not likely to see negative-rate mortgages any time soon (although the New York Times reports that some adjustable rate mortgages in Denmark did drop below zero).

There’s another consequence of negative interest rates that’s far less benign. Negative interest rates tend to drive down the value of a country’s currency, making its exports cheaper and more competitive in global markets. That may be very good for that country, but when several try to do it at the same time a currency war could erupt, leading to a potential shock to the global economy.  And those negative rates overseas are currently depressing interest rates in the U.S. according to Scott Minerd, global chief investment officer for Guggenheim Partners.  That is making it difficult for the Fed to normalize rates, which many economists argue is needed end the distortion in financial markets caused by quantitative easing.

What should an investor due in this situation? The safest investments such as U.S. treasuries are providing a paltry 1.9% annual return over 10 years.  Higher-yielding junk bonds offer better returns, but entail much higher risk if the economy should become stressed.  Treasury Inflation Protection Securities (TIPS) might be a viable option, given that they are currently priced to return about 1.4% over the next five years. If the U.S. economy continues on its current trajectory, and inflation increases at least as far as the Fed’s target of 2%, TIPS would generate a better return than treasuries. And they are both risk-free.

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