Negative interest rates are widely discussed these days as a monetary policy tool to support economic growth. President Donald Trump is a huge fan of low or negative rates and has been browbeating Federal Reserve Chairman Jerome Powell, whom he appointed in 2017, to cut interest rates to zero or even lower. Powell and his colleagues should think long and hard before capitulating.
The apparent goal is to keep the economy percolating until after next year’s presidential election. The Fed appeased the President last month, making a modest quarter-point cut. Egged on by Trump, they seem poised to lower rates further this year.
Negative interest rates have become commonplace in Europe and Japan. Central banks in Denmark, Switzerland, Sweden, Japan, and the European Central Bank have slashed rates below zero to shore up weak economies or strengthen their currencies. The notion is that weakening a country’s currency makes it a less attractive investment than other currencies, giving the country’s exports a competitive advantage. Worldwide, there is more than $17 trillion in debt with negative yields, almost half of it in euros. The majority of the balance is in Japanese yen. Almost all of it is sovereign debt.
Central banks usually pay commercial banks interest on the reserves they keep at the central bank. Under a negative rate policy, the commercial institutions are required to pay interest on any surplus cash beyond what regulators say banks must keep on hand. This penalty is designed to incentivize commercial banks to lend more money. The view is that low or negative interest rates encourage businesses to invest and consumers to spend rather than pay a fee to keep their money safe. Loans put money into circulation and generate economic activity.
Lower or negative interest rates present both costs and benefits for consumers.
Imagine if you go to the bank for a loan and are told the bank will pay you for taking it. Who in their right mind rejects such an offer? Conversely, if you make a deposit, under a negative interest rate scenario you are actually paying the bank to hold your money.
A big concern, which has yet to be explained, is the impact of negative interest rates on money market funds, which are a foundational investment for many households. Negative interest rates reward borrowers at the expense of lenders or savers. The goal is to bring future consumption into the present.
One potential danger of this approach is the liquidity trap that occurs when interest rates are so low that they reduce the flow of money to the Main Street economy. Instead, it goes into investments that don’t generate economic activity, such as the stock market, as people desperately chase higher yields and push up stock prices.
Interest rate cuts tend to stimulate the stock market by making real returns on bonds less competitive. The President seems to think that makes for good economic policy. Negative interest rates might actually lead to lower interest costs on government debt. Debt service is one of the fastest growing drivers of federal spending.
Low interest rates are old hat. Even during the Obama administration, when the economy rarely topped 2 percent annual growth, business did not pick up when money was cheap. For the last decade, the low interest rate scenario has been a secret tax on savers, who are not generally speculators in the stock market.
Millions of Americans are either behind in the race to save for retirement or living off their interest income. They may spend less in a negative interest rate environment, which would reduce economic activity.
How using this unconventional monetary policy will work in the United States is a mystery. It could leave the Fed without any ammunition when an actual recession hits and could increase the likelihood that the President is reelected. One can only hope that Powell and company make the right economic call.