Are Negative Interest Rates in Our Future?

Spread the love of economics

Recent economic indicators from the U.S. show a weak jobs report in September 2015, with industrial production down and a weakening world economy for U.S. exports. These indicators begin to raise the question; will the U.S. enter a recession in late 2015 or early 2016? And if the U.S. does enter a recession, will that lead the Federal Reserve to begin a process of negative interest rates?

In March 2015, this Amateur Economist began to openly discuss the underlying weakness of the U.S. economy and the various forces causing it; U.S. Recession in Late 2015 or 2016?. Since then, others have now started to consider the possibility of a recession.

All that said, looking at data from the last few weeks suggests that we need to be on “recession watch.” Global GDP is clearly slowing down, and the data we are getting from the US suggests that we are going to see a serious falloff in GDP over the next few quarters. “Thoughts from the Frontline – Recession Watch” By John Mauldin | Oct 04, 2015.

When recessions occur, the U.S. government reacts in two ways; by legislative actions through fiscal policy (infrastructure investment, tax reduction and/or jobs programs) and/or by actions through monetary policy by the Federal Reserve. Due to the recent inability of legislative and congressional actions in dealing with matters involving the U.S. economy (or much else for that matter), the Federal Reserve has taken the lead for the health and welfare of the U.S. economy.

The primary tool for the Federal Reserve in monetary policy is the control over interest rates. In broad terms, the Federal Reserve controls interest rates by changes in the Federal Funds Rate. Currently, the Federal Reserve is paying depository institutions and banks a 0.25% interest rate for the excess reserves that they are holding. Banks and financial institutions use this, “Fed Funds Rate” as a benchmark for the interest rate they charge for loans and the interest they pay on depository accounts. This historical low rate has been in place since 2008 – for an unprecedented 7 years. Though it is possible, but increasingly unlikely, that the rate will be increased in December 2015.

Regardless of whether the rate increases in December 2015, should a recession start in late 2015 or 2016, the Fed Funds Rate would still be extraordinarily low (more than likely in the 0.25% – 0.75% range) for the beginning of a recessionary economic event. Given that interest rates are the number one tool the Federal Reserve has to combat a recession, the Federal Reserve may not only lower the Federal Funds rate to zero, but possibly take them into negative territory.

And how does one have a negative interest rate? In an odd way, many Americans live with them every day; through bank checking and savings account fees. The general concept of saving money and placing money in a bank, is that a bank would pay interest on those monies. However, in today’s world, savings accounts often have high minimums – and should a balance fall below a minimum amount, the bank might charge a fee to the account. In effect, this is a negative interest rate (fee) as a savings account holder is charged for having money in a banking institution. A saver might question whether it is best to simply take the money out of the bank and spend it…

Negative interest rates used as a monetary policy tool by the Federal Reserve might work in much the same way. The Federal Reserve would stop paying depositors and financial institutions and start charging a “safekeeping” fee of some amount, perhaps 0.25% for keeping the cash in reserve.  This action, in theory at least, would force interest rates down as financial institutions would attempt to not hold short-term funds but would loan the money out – which would, in turn (and in theory), stimulate the economy.

Of course with every action, there are unforeseen consequences. Negative interest rates might encourage the hoarding of cash vs. being charged to keep it in a bank. Banks, attempting to increase profits, could begin charging their customers fees to simply deposit and hold their money. This is already happening in certain circles. Savings instruments such as CD’s, savings accounts and short-term Treasuries would yield little or be effectively eliminated.

So what to do with the excess cash? More than likely, asset bubbles would form in the equities and real estate markets as investors and savers would purchase items vs. depositing the cash in the bank and being charged for the privilege. Holders of large amounts of cash, such as pension funds, insurance companies and some large corporations, would be forced to reduce or liquidate excess cash and start purchasing assets or invest in possibly risky financial instruments. Businesses, consumers and government entities might find it more advantageous to go into more debt as it will cost less than to hold cash or savings.

Negative interest rates were briefly used in the Euro zone several years ago with limited or nominal success. It is unknown what effects, both long-term and short-term, they might have on the American economy. Regardless, by not raising interest rates sooner, the Federal Reserve has rendered its main monetary policy weapon useless should it, nay – when it is needed, to fight the next recession.