Understanding Negative Interest Rates and their Impact on the Economy: Insights from Financial Advisor Tim Hayes

The European Central Bank, Sweden, Denmark, Switzerland, and Japan have all implemented some form of ‘negative interest.’ However, none of these countries or regions have seen commercial banks charging their customers for depositing money.[i]

With the coronavirus causing havoc on the world’s economies, there is much talk in the financial press about ‘negative interest’ rates—which adds yet another oxymoron to a list that includes ‘Great Depression,’ ‘jumbo shrimp,’ and ‘open secret.’

U.S. Federal Reserve Chairman Jerome Powell is adamant that the U.S. Central Bank will not resort to negative interest rates.

Today, however, at .05%, the federal funds rate is basically at zero, so unless they are willing to go negative, this leaves the Federal Reserve without its main tool for lowering interest rates to try to stimulate the economy.

Quantitative Easing

Chairman Powell seems more comfortable with quantitative easing (QE), which is when the Federal Reserve creates money to purchase financial assets. The seller of those financial assets gets a new bank deposit that can be used to buy a new financial asset.

Hopefully, this pushes up the value of financial assets, leading to a wealth effect where, seeing their net worth rising, the assets holders spend more.

In two months, the Federal Reserve has increased its balance sheet by almost three trillion dollars, helped the stock market recover two-thirds of its losses, and stabilized the bond market.

We will have to wait and see whether it will lead to additional spending during a pandemic or just further wealth inequality.

Negative Interest

It is a head-scratcher that a person could deposit $1,000 in their bank account and get $995 back; they might as well have kept their money under the proverbial mattress.

The European Central Bank, Sweden, Denmark, Switzerland, and Japan have all implemented some form of ‘negative interest.’ However, none of these countries or regions have seen commercial banks charging their customers for depositing money.^[i]

Instead, what the financial press is referring to is another desperate, misguided attempt by the central banks of these countries to increase bank lending. What the central banks are hoping for is that the commercial banks will decide to offer more loans rather than leaving their money at the central bank and watching it deplete from the deposit fees.

The Myth of the Money Multiplier

However, we had seen this scenario before when the central banks of the world instituted quantitative easing. In the United States, bank reserves jumped from $46 billion in 2008 to around $5 trillion. During this time, respected economists, journalists, and politicians opined about possible inflation that commercial banks lending those recently acquired reserves caused.^[ii]

For example, on January 3, 2013, former senator, Phil Gramm, and Stanford economist, John Taylor, wrote the following in the Wall Street Journal: ‘With banks holding excess reserves rather than lending them out—and with velocity at a 50-year low and falling—the inflation rate has stayed close to the Fed’s 2% target.’^[iii]

Also, in the Journal during the same month, reporters, Jon Hilsenrath and Kristina Peterson, wrote, ‘One reason the hawks have been wrong about inflation is that the money that the Fed has pumped into the financial system has tended to sit at banks without being lent to customers.’ ^[iv]

Inflation never happened because the theory that reserves multiply into loans—the so-called ‘money multiplier’—is a myth. It is a relic of a time when countries were on the gold standard and, theoretically, the amount of gold a central bank owned dictated commercial bank lending.

In today’s world, the number of reserves that banks deposit at their central bank has almost no bearing on credit creation. Nor can the banking system reduce the total amount of reserves by making loans.

Let’s say that I borrow $100,000 from Bank A. Along with the loan, Bank A will credit me back with a deposit for $100,000. If the next day I move the $100,000 from Bank A to Bank B, I will still have my $100,000 loan with Bank A, but the money will now be in Bank B.

Bank A will then transfer $100,000 from its reserve account at the Federal Reserve to Bank B’s reserve account. Bank A will have less money earning negative rates; however, Bank B will have an extra $100,000 exposed to negative rates. Thus, making a loan will merely move reserves from one bank’s reserve account to another bank’s reserve account.

A Better Way Forward

I am not one who believes that central banks are evil or that we need to audit our own central bank, the Federal Reserve. But a central bank penalizing banks for having too many reserves, when it was the central bank’s bond purchases (quantitative easing) that had credited the banks with the reserves in the first place, brings to mind a famous quote from a prominent but misguided economist, Karl Marx, stating that history repeats itself, ‘the first time as tragedy [financial crisis], the second time as farce [negative interest rates].’ ^[v]

For the past twenty-five years, central banks have dominated the economic landscape. In his book Maestro: Greenspan‘s Fed and the American Boom, Bob Woodward referred to one central banker, Alan Greenspan, as ‘the Maestro’ for his supposed ability to orchestrate economic growth. ^[vi]

But if the economy continues to slow or goes into a prolonged recession and our central bank, the Federal Reserve, relents and joins other central banks in implementing negative interest rates, the ineffectiveness of that policy might create the opening for what Thomas Kuhn called a paradigm shift in his famous book The Structure of Scientific Revolutions ^[vii]. A paradigm shift is a move from a finance- and banking-based economy to one built on the blocking and tackling of economic growth: entrepreneurship, education, manufacturing, investment, and infrastructure.

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third party sites should not be considered an endorsement of content, which we cannot verify completeness or accuracy of.