3 Things To Know About Negative Interest Rates
Summary
- Economic conditions do not immediately suggest a negative interest rate policy is around the corner, but it could still become a reality if the economy goes south.
- The only reason negative rates are possible today is because central banks have evolved and gained significantly more control over banks and monetary policy.
- The justification for negative interest rate policies (sometimes called NIRPs) is that they are useful to combat deflation.
- In the event of a big downturn, there’s a chance long-term rates could still be driven into negative territory thanks to other tools, like quantitative easing, which drive up bond prices and drive down yields.
Following the Great Recession, interest rates hovered near zero for years. From 2016 to 2018, they marched slowly and steadily higher—a sign of recovery. But in the last 11 months, they have reversed course again. In September, the Federal Reserve slashed interest rates for the second time in seven weeks, continuing what’s been one of the sharpest declines in interest rates in recent history. Additionally, market probabilities imply there’s at least a 90% chance another cut is coming. Falling expectations for growth, negative interest rates in Europe and Japan, and Fed policy have all played a role in this recent downtrend.
Could interest rates in the U.S. actually fall below zero? It is often said that bond markets foreshadow what’s to come in equity markets, and about one-third of global bonds and 45 percent of non-U.S. bonds currently sport sub-zero rates. President Trump has been a vocal proponent of using negative interest rates to boost the economy, while JPMorgan Chase & Co. CEO Jamie Dimon said preparing for them represents a “normal course of risk management,” per NBC News.
Yet there are greater obstacles to negative interest rates here than abroad, and Fed chairman Jerome Powell recently dismissed the tactic outright. In all, economic conditions do not immediately suggest a negative interest rate policy is around the corner, but it could still become a reality if the economy goes south. And either way, it’s good to understand the situation. Here are three things everyone should know about negative interest rates.
1. Negative interest rates are an aberration.
In the long sweep of human history, negative interest rates are extremely rare. The only reason negative rates are possible today is because central banks have evolved and gained significantly more control over banks and monetary policy. Commercial banks are required, through regulation, to hold a certain fraction of their deposits in the central bank. The rest they can lend. When the economy is weak, commercial banks often hold a larger pile of reserves. Negative interest rates, though, encourage commercial banks to lend more and store less.
Similar incentivizing takes place at the consumer level. Normally, when you keep money in a bank, you receive interest on it over time, as an incentive to save. With negative interest rates, you instead pay to keep your money in the bank. As a result, those who borrow money are rewarded, while those who save are penalized. It’s the inverse of what’s logical—which is why it’s so rare.
In “A History of Interest Rates,” published in 1963, Sidney Homer wrote that rates lower than 3% were virtually unknown in Mesopotamia, Greece, Rome, or pre-modern Europe. Now, rates below 1% remain rare, while data from the Bank of England shows that there were only three months between 1935 and 2012 when the yield on 10-year UK government bonds dropped below 2%.
While central banks have fairly direct control of short-term rates, longer-term rates are set largely by market forces. However, central banks have been able to push long-term bond rates into negative territory by their intervention in bond markets and their purchase of longer-term debt.
2. They are meant to combat deflation.
The justification for negative interest rate policies (sometimes called NIRPs) is that they are useful in combating deflation. When viewed in the context of low global growth and current deflationary risks, negative rates are a rational, albeit experimental, response by central banks. Deflation takes places when the value of currencies rise and the prices of goods and services falls. This causes people to hold tight to their money instead of spending it, with the resulting drop in demand propelling an even greater drop in prices. Flipping interest rates below zero, then, can stimulate lending and spending.
Actually assessing the impact of NIRP on spending can be difficult to do, though. The impact on foreign exchange markets, on the other hand, is easier to observe. With investors unable to earn interest on their own currency, they turn to foreign markets instead. This lowers their own currency’s value, thus reducing deflation and boosting exports.
Still, many adverse effects of NIRPs have been documented as well. Negative rates hurt bank profitability and paradoxically have been shown to decrease loan demand. They also hurt the ability of insurance companies and pension funds to meet the obligations of their claimants and have the potential to create asset bubbles. For the cherry on top, J.P. Morgan recently noted that negative rates can reduce liquidity in the credit market and exacerbate inequalities. And yet, overall, the practical obstacles to negative rates have already been shown to be less than feared.
3. Negative rates remain unlikely in the U.S.
At their core, negative yields on government bonds in Europe and Japan reflect investor pessimism about global economic growth and a belief that central banks could maintain negative interest rates for years to come. But as mentioned already, negative interest rates face specific roadblocks here in the U.S. The size and diversity of non-bank debt markets means that bank lending plays a smaller role here at home than in does in Europe and Japan.
On top of that, the U.S. is the world’s biggest financial market. The aforementioned adverse affects, then, could be amplified—and many experts have already voiced concerns about such a policy. Still, while negative rates may not come to our markets, negative rates abroad do exert a downward pressure on rates at home. Even falling rates could boost the economy a bit; strategists at Goldman Sachs wrote last week that falling rates could lift U.S. economic growth to 2.5% in coming quarters.
At the end of the day, negative interest rates are probably unlikely—and are definitely not right around the corner. While Powell doesn’t think negative interest rates represent a savvy approach, even in times of crisis, other members of the Fed have said they would be open to exploring the possibility. And as already mentioned, the Fed only sets short-term rates. In the event of a big downturn, there’s a chance long-term rates could still be driven into negative territory thanks to other tools, like quantitative easing, which drive up bond prices and drive down yields. Plus, the fact that negative interest rates already exist abroad could continue to put downward pressure on rates here in the U.S., even if they don’t dip below zero.
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