Are Negative Interest Rates on our Way?
There’s a saying that a bank is a place where they lend you an umbrella in fair weather and ask it back when it begins to rain. A place that will lend you money when you prove that you have plenty of cash and don’t need it.
Now, imagine a world where banks actually pay you for taking loans and charge you for saving it. Yes, you read it right, we are talking about “Negative Interest Rates”. It is exactly what it sounds like, the rate when it falls below 0.
Across the world, Central banks are reducing interest rates (which is a conventional monetary policy measure) to infuse liquidity into the economy. The US economy reduced its interest rate to 0% from 1% for the same reason. Imagine a 0% interest rate, you pay nothing for the loans that you take. But this is not it, President Donald Trump has different plans, he recently tweeted that the US should accept the "GIFT" of negative interest rates. But well, Jerome Powell, head of the US Federal Reserve, which sets US monetary policy, rejected Trump’s plea. Hmmm, interesting! But what makes Trump believe that negative interest rates would help the economy? And what makes Powell believe otherwise? Let’s dive deeper into this.
Following the global financial crisis in 2008, Central governments in Europe and Japan started resorting to negative interest rates as a policy measure to infuse liquidity. But why would they do that? The most important reason is to save an economy from falling into a deflationary trap. Deflationary trap? What’s that? The basic equation of demand and supply says that when the price is less the demand increases, but when the price is more the demand tends to decrease. Now when people hold too much money instead of spending it, in uncertain times like the global financial crisis or the Covid-19, the economy sees a reduction in demand and also a reduction in the price of goods and services (deflation). Deflation is pretty bad for an economy, the money that you hold is actually increasing in absolute quantity, which further demotivates you from consumption. And this leads to a further decline in prices. It’s a trap! So here the Central bank steps in by reducing the interest rate that is already 0%. Well, this according to central banks would lead to an increase in borrowing and spending. Of course, why would you want to keep your money in your bank account when you can instead borrow money and make money on the money that you borrowed. And also, why would a bank park money at the central bank when it is being asked to pay for it?
Goldman Sachs noted last week the argument for negative rates in the US has strengthened amid fears that the recession driven by the coronavirus will be deep and prolonged.
Another explanation is that a country reduces its interest rates to devalue its currency. Why would a country want to devalue its own currency?. A devalued currency pushes people from abroad investing in an economy out and also, lead to a growth in demand for the country’s exports. This is one of the main reasons why Donald Trump is advocating negative interest rates all this while.
Well, as we mentioned above that Trump doesn’t have the authority to make rates negative, it is Powell who has the authority to do it. But well, he has contradictory views. He believes that negative interest rates would put downward pressure on bank profitability and in turn limit credit expansion. Lenders make money from the interest rates, such a policy would reduce their profitability and in turn deterring them from lending. And again, this seems to be a good deal if the borrower does not hold credit risk. Banks don’t want to lend at a negative interest rate to a risky borrower. So if rates remain negative for long, financial institutions would not be motivated to lend, hurting businesses, consumers and the economy at large.
Well, this is not it. Individual investors that rely on a fixed income from say fixed income securities like long dated bonds or short term treasury bills would also be probably forced to invest in risky assets to sustain themselves, which would possibly put them into a greater risk of investment losses.
So yes maybe, Powell is right. Several people from the industry also believe that the unconventional measures taken by the Federal Reserve so far to protect the US economy from the Pandemic would indeed prove to be much better than negative interest rates. But there is also another set of industrialists that believe that negative interest rates in the US are inevitable. Are they inevitable? Will we see negative interest rates in the US soon? Only time will tell.
Disclaimer: This post originally appeared on Forexonomics written by Sakshi Jain and has been reproduced here (with certain minor edits) with her kind permission.