By T. Eric Reich
Lately, we have heard talk of negative interest rates as a monetary policy option from the Federal Reserve. Today I thought we would discuss what negative interest rates are, and do they make sense as a policy option. So what are negative interest rates? They are just like they sound. Instead of paying an interest rate on a loan, you are actually paid to take it.
Well, what they are really doing is charging them to leave their money in an account or essentially discouraging savings. Negative rates, however, are really only the domain of central banks at the present time. Why would a central bank want to discourage savings?
Some countries experience the opposite of inflation known as deflation. This occurs when there is very little spending and the economy starts moving backwards. Deflation can be far more dangerous than inflation so central banks try diligently to keep their economies growing. When all else fails, sometimes negative rates are employed to encourage economic spending and "jump start" the economy.
Negative interest rates have been a hot topic between President Donald Trump and Federal Reserve Chairman Jerome Powell. The idea behind them incentivizes the public to shift their monies to other more productive means rather than having them sit safely at a bank or other financial institution. The common thought behind them is, if it's costing you money to have it sitting in the bank you will invest it or make larger purchases such as a house or boat, or start a business.
Conventional monetary wisdom tells us that when we give banks money in our checking, savings, or certificate of deposit accounts that we expect an interest rate in return. That same wisdom also tells us that we are to be charged an interest rate when we borrow from banks for items such as mortgages, car loans, credit lines, etc.
Negative interest rates do the complete opposite. In a negative interest rate environment banks would charge you to keep your deposits with them and would essentially pay you to borrow from them. Here is an example: If negative interest rates were employed, and you borrowed from a bank to finance a home for $200,000. At the end of the loan period you may have only paid $195,000 for that house. The bank just paid you $5,000 to finance your home. I imagine many of you are wishing your mortgage company would do that right about now.
So the big question is does it work? The truth is we don't know. For starters, it has never been done in the United States before, but other nations have used negative interest rates to try and ignite their economies. Some of these countries are Japan, Germany, Sweden and Switzerland. Most of the data coming out of these countries seems to suggest a limited benefit but with longer term effects unknown.
Personally, they scare me, and I think they are a terrible idea. I think there are plenty of other creative ways to boost economic spending without resorting to negative rates. I say that because the context for consumers in America is different than it is for other countries. Our GDP is driven by consumer spending far more than most other nations. Therefore, it is easier for us to stimulate our economy than it is for a country like Japan for example.
As I see it, the long term effects to the strength of the United States dollar, which is regarded as the world benchmark for currency, the impact to the Federal Reserve's balance sheet, and the lack of proven effectiveness makes employing negative rates not only a questionable strategy, but also likely a very dangerous one.
Our current Fed policies have been working very well during hard economic times despite all their criticisms. And while some argue the Fed is almost "out of bullets," I think those fears are overblown. It is important to note that the Federal Reserve is on record stating they are against negative rates, but who knows if they would ever seriously consider them in the future.
For now, I would not expect to see such a radical policy option implemented by the Federal Reserve, but it certainly warrants watching it closely.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or firstname.lastname@example.org.