Negative Interest Rates In the US

By Modern Wealth Management

September 24, 2019

Negative Interest Rates In the US

What do Negative Interest Rates Mean for Savers, Investors, and the Economy?

There has been a lot of talk recently about negative interest rates in the US. You can’t turn on your television, computer, or phone without seeing some story about negative interest rates. The problem is that none of, or very few of these stories, actually take the time to educate their listeners/readers. You get a soundbite or a 300-word article that’s supposed to arm you with all the information you need. The reality is, there’s a lot more to understand about negative interest rates than those mediums can convey. So, I’m going to try and lay it out for you here today.

Ever since the “Great Recession,” central banks in developed countries have been struggling to fight the low growth/low inflation environments that have lingered in economies, using more forceful monetary policies. The Federal Reserve, in response to the financial crisis in 2008, actually took their Fed Funds rate to zero. Subsequently, it remained there until late 2015 when they finally began trying to “normalize” interest rates. By December of 2018, they’d gotten the rate up to 2.5%.

Learn more about Negative Interest Rates Around the Globe

The last hike in interest rates, in December 2018, caused the stock market to crash. As a result, the Federal Reserve had to seriously reassess its interest rate policy. They had plenty of people yelling in their ears about what they should do. This includes calls for them to take the rate back to zero or lower. As a result, in July of 2019, the Federal Reserve cut its Fed Funds rate by .25%. The first interest rate cut in 3 years. They just issued another .25% rate cut in September 2019. This is coming amid increasing talk about the possibility of negative interest rates in the US becoming a reality. But why?

Negative Interest Rates – A Brief History  

It’s long been believed “zero” was as low as interest rates could go. It was what economists and academics like to refer to as “the lower bound.” A point below which you could not go. And for a good reason. Who in their right mind would pay to deposit their cash into a depository institution?

The prevailing opinion was a real interest rate below zero would create a run on banks, as savers rushed to pull their cash and hurry home with it to stuff it into their Warren Buffet mattresses…you know…the ones with the secret zippered pockets in them where you can stash your cash. This meant that once interest rates reached zero, central banks were out of economic firepower.

Holding Cash

To find a way to give Central Banks more firepower where monetary policy was concerned, economists have been looking for creative ways to dissuade people from holding cash for centuries. It turns out they can be quite a creative bunch. In the 19th century, German merchant and theoretical economist Silvio Gesell proposed a tax on holding cash and also called for money that had an expiration date. Former Harvard economics professor Greg Mankiw suggested in 2009 we enact a lottery system. The system would randomly draw serial numbers on banknotes to be declared void. Therefore making it less than ideal for holding cash.

Not to be outdone, Harvard professor of public policy and economics Kenneth Rogoff, in his book “The Curse of Cash” called for the elimination of cash altogether. His rationale? He argues the world is awash in cash, much of which is used to finance tax evasion, drug trafficking, human trafficking, corruption, and terrorism. He believes its necessary to abolish cash so that central banks will be able to enact negative interest rates that are “well below zero,” which he sees as imperative to combat the next financial crisis. Phasing out cash would mean people would have no choice but to pay negative interest on their bonds and savings. I told you these guys were creative! 

Negative Interest Rates – A New Prevailing Wisdom? 

Denmark’s Central Bank was the first to enact a negative interest rate in 2012. To the surprise of almost all, the negative interest rates did not result in stress on the financial system. So, many of the European Central Banks followed suit in 2014. Then Japan joined them in negative interest rate territory two years later. Today, nearly 20 Central Banks have interest rates below zero. Switzerland has the lowest rate in the developed world, with a negative .75% interest rate.

The fact that these countries have dropped their interest rates to below zero, without also enacting any policy tools to make it painful to hold cash, is the prevailing wisdom about how low-interest rates can go before they cause stress on the financial system. It turns out that some people are willing to pay for the convenience of not having to hold their savings in cash.

Using the experience of Switzerland’s .75% move into negative interest rates, we can conclude that interest rates can go at least that low. Meaning the old notion of zero being the lower bound no longer holds. However, we don’t know where the lower bound is. No country has moved far enough into negative interest rate territory for us to understand how low we can go. Also, what combination of policies it might take to finally reach the bottom of the lower bound and cause a rush into cash.

Negative Interest Rates – How Do They Work 

The goal of negative interest rates is to force cash into more productive use. These include causing it to be lent and spent or used to purchase securities that will provide the returns needed by those who are dependent on their assets to produce income for retirement, funding pension obligations, hedging risk or other economically productive purposes. As most of you know, one of the functions of a Central bank is to hold money for commercial banks. Typically, the Central bank will pay the commercial banks interest on that money.

However, If the Central bank cuts interest rates to below zero, it means that they can charge the commercial banks interest on that money. In response, commercial banks can cut the interest rate that they pay their customers by the same amount and make their money back.

Consider the example of a pension fund or endowment with a deposit at a commercial bank. If interest rates drop, the fund might buy other types of financial assets with a higher return, like stocks or bonds. This buying pressure increases the demand for, and subsequently, the price of, these assets. This reallocation of capital how a rate cut gets transmitted to the broader financial market. As a result of the availability of cheaper money, banks might also be inclined to reduce the interest rates they charge on loans to remain competitive.

Inflation and Economic Activity

As stated earlier, but it bears repeating, the aim of the central bank is to increase economic activity. That should spur inflation, bringing it up from the low levels we’ve seen here in our country. Which is what the US Fed has been trying to do for the last 10 years. This is to prevent the deflationary pressures that some countries are currently dealing with. There are several ways this can play itself out with negative interest rates in the US. 

With cash costing them money, rather than holding it, banks would be more inclined to lend money to households and companies. Businesses, with access to the cheaper capital created by a negative interest rate, can invest more in people, expansion, and capital investments at a reduced cost. Families could take the opportunity to save less, change their savings practices to include purchasing stocks or bonds which may be rising due to higher demand, or they could borrow and spend more, further stimulating economic activity. All the above and more could be expected to occur in the event of negative interest rates in the US. It’s also possible that the US dollar could fall in value due to a lack of demand. Which would increase the demand for our exports as they would become cheaper for other countries to buy.

Should the US Go Negative?

As we’ve noted here, several countries have gone down this path without causing undue stress to their financial systems, which may be why we’re now flirting with the idea of negative interest rates in the US to help perpetuate the economic expansion we’ve been experiencing for the last 10 years, which has slowed as of late. It seems that we’ve reached a point in history where we’ve begun to believe that we can, through monetary policy, avoid the pain of a slowing or (heaven forbid) recessionary economy. 

But can we? Should we? Are we really that smart, or are we really that dumb?

Negative Interest Rates in the US – Will They Work? 

First of all, it’s not at all clear that, even amid the many calls for negative interest rates in the US, we will get to the point where the Federal Reserve decides that negative interest rates are necessary here in the US. In his most recent press conference, Fed Chairman Jerome Powell made it clear that negative interest rates are not on their list of things to consider, now or in the foreseeable future. He further stated that they would use other, more conventional policy tools to accomplish their dual mandate before considering negative interest rates in the US. But what if they did? Would it work?  

One of the problems with negative interest rates in the US, or any country with an aging population is the tendency of older citizens to hunker down and cut spending rather than put their assets at risk in equities or other investment assets. And here in the US 10,000 people a day turn 65…for the next 10 years. That phenomenon has already been occurring for the last 8 years. That’s a lot of people who have lost, or are losing, their appetite for risk; the very thing a negative interest rate environment requires them to take.

Virtuous Cycles

However, since banks are hesitant to pass on negative deposit rates to their customers, let’s consider the possibility that older savers won’t move to take their money out of their savings accounts. Instead, resigning themselves to accepting a return to zero interest on their cash for a period of time. The reality is that all of those deposits don’t just set in the bank. They are lent to other consumers for them to use for a multitude of purposes like home, car, furnishings, and other purchases which help get the economy growing. Businesses, due to higher demand, must add people, production, inventory, etc. That means more people are working, earning wages, paying taxes, and purchasing additional goods and services. This is what we call a “virtuous cycle” which improves the economic and financial conditions for everyone.

Negative Interest Rates in the US – Those Left Behind 

Everyone that is, except for the “saver” who is risk-averse. Their situation, for as long as the zero or negative interest rate environment remains, gets worse; unless they are willing and/or able to change their behavior and assume some level of risk to maintain their lifestyle. We witnessed this phenomenon in the “Great Recession” when interest rates only went to zero. There was no way to earn interest on your deposit accounts anymore. Money Markets, for a brief period of time, lost value. Bonds were in such high demand that there was very little yield available to generate income. They were selling at such a premium you weren’t even able to get all your money back when they matured.  

It’s not difficult to imagine what would happen to cash accounts and bonds in a negative interest rate environment where yield was at an extreme premium. There would literally be no place for the risk-averse to go for income. That is except the one place they have no stomach to go…and that’s into equities. And if they chose not to go, they would be the ones left behind for as long as the negative interest rates remained.

Negative Interest Rates in the US – Not Likely 

The reality is there are more effective, less exclusionary, policies the Federal Reserve can implement in the case of another financial crisis. In that event, we’d likely see something much more akin to the zero interest rate policies, asset purchases, and cash infusions that we saw during the “Great Recession”.

It’s difficult, and frankly scary, to imagine an economic environment in which negative interest rates in the US made sense to the majority of those paying attention to such things.

There is a lot more to explore where negative interest rates are concerned, but we’ll save that for another article.

Stay in Contact

Until then, know that we are ever vigilant in monitoring the economy, and watching the horizon, for potential problems that are both seen and unseen, in order to protect your assets to the best of our ability, and keep you in a position to focus on the things that matter most to you. 

Not a client of Modern Wealth Management and you’d like to find out if your portfolio is going to get you where you want to go without undue risk? Schedule a complimentary consultation below or give us a call at 913-393-1000. We’ll get you set up to meet with an advisor who can help you with all your questions.

If you’re a client and want to know what negative interest rates might mean to your retirement plan, you know what to do. Juls will get you on the schedule.  

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.