Negative Interest Rates: Understanding the Inconceivable
One of the clearest indications that the global economy is in crisis is the fact that $7 trillion worth of bonds are trading with a negative yield. That means the owners of those bonds are guaranteed to lose money unless interest rates plunge even further into negative territory. Until recently, the very idea of negative interest rates was inconceivable. Why is this happening?
There are five reasons the interest rates on so many bonds have turned negative. The first three are related to falling inflation, since the inflation rate is the main determinate of interest rates:
- Globalization circumvents the domestic bottlenecks that used to cause inflation.
- Manufacturing in ultra low wage countries drives down the cost of production and product prices.
- Fiat money creation produces an economic boom that creates excess capacity and falling product prices.
- Fiat money creation changes the Supply and Demand balance for Money and pushes down yields.
- The imposition of a Negative Interest Rate Policy (NIRP) by some central banks puts downward pressure on all interest rates.
This last reason, NIRP, has captured the headlines of late. In January, The Bank of Japan, joined the European Central Bank, and the central banks of Switzerland, Sweden and Denmark in charging commercial banks interest on the reserves those banks deposit at their central bank. Fears are growing that the Fed also intends to introduce a Negative Interest Rate Policy.
Charging interest on bank reserves is an extraordinary measure. Here’s what the central banks hope to achieve by it:
• To encourage banks to lend more and to lend at lower interest rates.
• To push down interest rates across the yield curve.
• To encourage savers to spend more freely.
• To discourage capital inflows into a country.
• To Depreciate the Currency.
• To lift the inflation rate, i.e. prevent deflation.
The results of this policy have been mixed. NIRP has been effective in holding down or pushing down the value of the currency where they have been imposed. This may have helped in the fight to prevent deflation (by making imports more expensive), but the level of inflation remains very low in every case nonetheless. Meanwhile, there is not much evidence that banks have lent more or that savers have spent more.
It is far from certain that the benefits of NIRP outweigh its numerous negative consequences, which include the following:
• By further pushing down interest rates across the yield curve, it punishes savers.
• And, it makes it difficult for Pension Funds and Insurance companies to earn enough income to meet their obligations.
• It also squeezes banks’ margins, reduces their profitability and causes their share prices to fall, causing a negative wealth effect.
• NIRP pushes banks to make loans when they believe there are no viable lending opportunities. That’s likely to cause NPLs to rise.
• NIRP escalates the Currency Wars.
• It doesn’t cancel Government Debt the way QE does.
• And, in order to be effective, NIRP might require a “ban on Cash” and the confiscation of Gold.
• Finally, NIRP could induce Panic and Revolt among the general public. People are fond of cash and increasingly fond of Gold.
Thus far, with only a few exceptions, commercial banks have not yet passed on the negative interest rates to their customers by forcing them to pay interest on the deposits they hold at the commercial banks. That could change, however. Throughout the developed economies, inflation rates are very low. Those economies may soon experience outright deflation. If deflation takes hold, it is likely that depositors will be charged (a negative interest rate) on their deposits.
The economic consequences of such a radical departure from the normal workings of a capitalist system are unknown. The psychological consequences are certain to be profound. How long banks, insurance companies, pension funds and mutual funds could survive in a negative interest rate environment is anyone’s guess; but their prospects would not be promising.
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