Negative Interest Rates

Miscellaneous Current Events
1

I read that Obama’s advisors say that to sufficiently stimulate the economy a Negative Interest Rate of -4 to -5% is needed.

What effect does a Negative Interest Rate have? On a bank account, a CD, on sthe Stock Market.? Can anyone tell me?

*Interest rate threads*
2

A negative interest rate would create incentives for banks to borrow as much money as possible from the Fed, since they would earn a profit by doing so. Then these banks would be more able to lend this money out recklessly, creating inflation, and increasing the velocity of money.

3

wouldn’t they not even need to lend out the money? Just wait a year and you only have to pay 5% back?

I guess with inflation at around 10% you would still have to lend it out to break even at -5% interest huh…

4

They wouldn’t have to, but there probably would be a game theory-esque situation where if you don’t lend, then others will, which will cause inflation and devalue your profits. The ultimate goal of negative interest rates is to bring down interest rates that businesses and homebuyers have to pay to near-zero.

5

If Zimbabwae, Argentina, France, Germany in the 1920s are any indication then we can expect the following:

  1. Massive government borrowing and intervention in the economy. This money enters the banking system by the fed lending it to the banks who in turn lend it to the US Federal government.

  2. Consumers will see rising prices led by prices on services.

  3. Stock market expansion. As the dollars are worth less then foreigners will use their money to buy US assets driving up prices.

  4. Physical asset prices: Commodities, Homes, autos, gold, jewerly, appliances, etc will explode upward.

  5. Businesses creation and productivity will grind to a halt as people have to consume the money before it is worth less.

  6. Imports will have a quick spike as consumers attempt to rid themselves of cash and then will fall quickly to nothing.

  7. There will be a world wide depression as banks in foreign countries holding gazillions of worthless dollars and dollar equivalents dump them in mass.

6

Hang on: I know that in a democracy the ruling party has no long term incentives to keep things going well in the long term… but doesn’t the federal reserve have a vested interest in the long term health of America? Even if all they want is our money don’t they get more of it if they keep the boat from sinking?

7

The Fed is only interested in supporting its member banks and appeasing the congress. It is supposed to create economic stability, economies are only stable without inflation, and maintain full employment which can be only done with complete free markets.

You correct in stated principal. The Fed is supposed to manage the economy through the interest rates based upon its aggregate statistics. According to conventional theory, the Fed will courageously create money for its benefactors (I do not understand why this is courageous?) and then use its superior knowledge to stop inflating and manage a slow deflation once the economy gets rolling again. It is as if the complex economy of the USA is really a simple motor. When consumers stop spending then the Fed must press the gas. Similarly when consumers spend too much then the Fed must put on the breaks.

Of course the Austrians would argue that the whole theory is crap. The Fed can not expand the economy nor increase output. It can divert resources away from consumers priorities leaving people to think production is increasing. Some of these diversions use more human work than others and thus may actually increase the level of employment. Eventually this diversion of real resources becomes so out of line with consumer preferences that consumers force a re-allignment commonly called a recession or panic. Then the Fed and govenrment step in to turn the recession or panic into a depression.

8

You’ve got it the wrong way around. Record low interest rates would encourage the dollar carry trade, which is when investors borrow US dollars and purchase assets denominated in other, high-yielding and higher-interest currencies. This would push up foreign stock markets more than anything. The US stock market would only rise because lower interest rates would simply encourage the purchase of more US stocks.

Actually, net exports would increase since a devalued dollar would make American products cheaper relative to foreign goods.

9

Everything since the March bottom has been a massive carry trade. As the Fed has said essentially “we will keep interest rates at 0% and continue to devalue the dollar” that essentially forces dollar holders (ie. Treasury holders) to find somewhere else to put their money. What the Fed did was increase the currency risk of the USD to force everyone out somewhere (like stocks) and make everyone feel better.

Obviously you can’t have a nominal negative interest rate. What happens is you’re earning 0% on your deposit or loan, and the bank charges account fees, etc. so that the net yield becomes effectively negative.

10

I was speaking in the longer term. In countries like Zimbabwae and some of the other hyper-inflations there were large gains in the stock markets as the currency became worthless.

You are correct that in the short term that exports would increase and that foreign buyers would jack up equity prices. But in the examples of hyper-inflation which is really what a negative interest rate is where the government is literally creating money and paying people to use it, we see net exports taper off and then fall. Similarly net imports have a rise and then fall as well. We have seen this in the US recentely where up to last summer exports have risen and imports have fallen until the fall when imports rose sharply. Either way the net result is that US would be come uncompetitive in exports as it could not buy raw materials and capital goods from foreigners as these would be too expensive. Thanks for the comment.

11

Me too.

I know. I also said that the US stock market would rise. But it wouldn’t rise for your stated reason: negative interest rates would encourage investors to borrow USD and invest in foreign currencies and assets priced in foreign currencies, since the yields for foreign assets would be higher. Think about it like this: You’re an investor, interest rates in the United States are low, the USD is trending downwards compared to other currencies, foreign countries have higher interest rates, and foreign currencies are uptrending compared to the USD. If you borrow USD and invest in a foreign currency (like the AUD), not only will you earn a profit off of the fact that the AUD will became stronger vs. the USD, but you will also earn a profit from the higher real interest rates in Australia.

The reason why Zimbabwean stock prices rose wasn’t because investors would take money from other countries and invest in the Zimbabwean stock market, but because the newly-printed money was often dumped into financial/credit markets, increasing the prices of financial assets before the general price level.

You’re contradicting yourself. Net exports means exports minus imports. Net imports means imports minus exports. So both net exports and net imports cannot increase. When one country has low real interest rates and high inflation and another country has high real interest rates and low inflation, then the value of the goods from the first country goes down in comparison to the value of the goods from the second country. This increases net exports.

Net exports increased because at the time there was high inflation and low real interest rates. Net exports decreased when US financial and credit markets collapsed, since the US supply of money and credit contracted, which reversed the USD’s downtrend and greatly strengthened the dollar relative to foreign currencies.

The net result would be a wearing out of capital, since investment in the US would fall dramatically if there ever were hyperinflation. However, net exports would increase regardless, as a weaker USD would mean that the prices of US goods would fall relative to the prices of foreign goods. Essentially, hyperinflation would price Americans out of foreign markets and price foreigners into US markets.

12

It’s all about “stimulating the economy” through spending. If you have, say, $1000 in a bank account and there’s a negative interest of, say, 4% after a year you’ll be left with $960.You’d have no interest in putting your money in a bank account. And according to the “let’s-spend-our-way-out-of-this-Depression” crowd instead of saving you should go out and buy, buy, buy. But more on that later.

Same thing about banks holding reserves with the Fed: today they earn a pittance but they do not lose anything (in absolute terms). But roll in a 4% negative interest rate: if a bank holds 1 billion with Fed and leaves it there after a year they are left with just 960 millions; the more money the bank holds in Fed reserves, the more they are bound to lose. This is seen as a possible cure for the present situation, with banks preferring to keep very large reserves with the central bank (it’s not just the US) and earning a pittance in interests than lending out. Call it a fine for not lending money if you like.

What are the possible consequences? US banks hold over 8 trillion in reserves. If I remember correctly the present money supply (US dollars) is around 1.5 trillion. Even if only a quarter of the reserves is lent out it would more than double the money supply: to free those reserves quickly banks will surely have to relax lending standards. Lot of easy credit (or “cheap money” if you like) would generate lot of malinvestment: it would make the past bubble look like child’s play. While I personally do not believe in a hyperinflationary scenario prices would climb rapidly, very rapidly. Think about the speculation we had on oil in the past two years and multiply for a factor of at least three in as many sectors as you like. As the dollar starts to plummet on currency markets (because so many US dollars are poured into them) other central banks will be faced with very difficult choices: keep on going with the Fed (as they’ve done over the past decade) or leave the US to drown in their own juice.

Mind that there’s no need for a negative interest rate to generate a similar scenario. All the US government would need to do is to (marginally) cut taxes, keep up present expenditures and monetize the deficit. Or simply increasing the amount of “stimulus money” they are directly handing out: how about a nice $500 check to replace your refrigerator or your computer? Or how about taking loans directly from Uncle Sam if you have “bad credit history”?

Finally a word about how this would affect your savings. The moment persons see there’s no point in saving money they’d react in two possible ways. Either they’d head out and spend like there’s no tomorrow or they’d start to pour money into “inflation insurance”. Given the present climate the former category will most likely far outnumber the latter. The common’s man a fool after all… So keep buying precious metals and investing in Asia while you can afford it.

13

There are some misconceptions about the effects of negative interest rates here. I don’t think NIR lead to hyperinflation because:

  1. no bank will create new credit money and lend it at a negative interest rate because they will immediately have to take a write down against their capital account. So they won’t do it. This means the money supply will not increase because interest rates are negative (however banks could still create to lend money if part of the term structure is in positive territory).

  2. what banks will do is pass negative rates on their reserves at the CB onto savers. As long as the bank restricts itself to intermediating between savers and borrowers without creating net new money, the bank will remain solvent and savers take the hit.

  3. although it is unlikely much if any new credit is created over and above the broad money supply at the point where rates go negative, velocity will certainly increase. However it would not lead to runaway hyperinflation because at some point the terms on borrowing becomes so attractive that demand for loans resurges, which causes a rise in the interest rate possibly back into positive territory. So the system is self limiting in this regard. This is different to zimbabwe where there was no market clearing process going on - just a unfettered printing of money.

All the above assumes of course than any negative interest rates applying to bank deposits are also applied to cash, either by some form of time stamping, or by just doing away with cash altogether.