Negative Interest Rates

It’s been two years since central banks in Europe decided to cut key interest rates below 0. In a grand experiment, central bankers, having leaned on every traditional lever to no avail, hope to revitalize economies that have remained sluggish. With Japan’s key rates dipping into negative territory this year, now over 500,000,000 people, participating in about 25% of the world’s economy, are living with negative interest rates.

Not in the US…Yet

No one can yet say with authority whether the approach is working. But in an increasingly globalized economy, the effects of negative interest rates are being watched very carefully. Here in the US, Federal Reserve Chair Janet Yellin recently said that she “would not completely rule out the use of negative interest rates in some future very adverse scenario,” but indicated the tool would need to be understood more fully before any kind of US implementation. For now, the Fed’s plan is to raise rates gradually.

In Theory

Rates that punish savers and reward borrowers should cause an increase in the demand for loans. The general idea is to stimulate economies by driving a significant increase in borrowing, which should increase spending. European economies such as Sweden and Denmark, which have been struggling with shortages of credit, slow employment growth and a threat of deflation for years, see negative rates as a means to boost lending on a grand scale. Central banks are dropping key rates below 0 in an effort to pressure banks to lend more, while reducing the costs of borrowing for consumers and businesses.

What To Look For

One concern about negative rates is that consumers will cease to make deposits. Rather than pay the bank to keep their money safe, there’s a danger they will keep cash. If enough people do that, retail banks would lose a crucial source of funds. It is even feared that dropping rates below 0 could trigger a run on the banks. So far that has not happened, but it is hard to predict how any given population might react.

Another potential backfire could occur should banks decide to absorb the cost of negative interest, thus shrinking their profit margins. If the gap between lending and deposit rates shrinks, the banks may actually decrease lending, a reaction that would work directly against the goals of the central banks.

Yet another fear is that, if more central banks should implement a negative interest strategy, the world could be plunged into extremely harmful currency wars. National currencies could be repeatedly devalued as a means to better compete in trade with each other, causing a host of global economic problems that might be worse than the situation which caused the banks to go negative in the first place.

Negative rates are an experimental tool currently being tested around the world. While it may not be time to plan for a US implementation, it is a good time to observe what works – and what doesn’t – while other nations experiment on themselves. Furthermore, it never hurts to understand how major economies are behaving, as the world continues to draw us all closer together into a single global economy, in which the decisions made by foreign nations and investors increasingly affect markets here at home.

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