What if Negative Interest Rates are the New Normal?

Last year, German savers with more than €100,000 in their bank accounts woke to the news that they now faced a 0.4% annual charge.

Central Bankers brought in negative interest rates, and the banks helped themselves to a slice of customer savings to cover the cost. There was no warning, it happened overnight and those impacted had no recourse.

Across many parts of the world, financial institutions are already charging their corporate clients to hold deposits, but this is one of the first instances in which there is punishment for personal depositors.

This move signals danger on the horizon.

Welcome to the parallel world of negative interest rates, fast becoming the new normal in parts of Europe and Asia as well as other jurisdictions across the globe. A quarter of the world economy is now subject to a negative base rate, including the Eurozone, Japan, Switzerland, Sweden, and Denmark. Even banks in the UK are quickly re-writing their rulebook to pave the way for negative rates.

Could it happen in the US? Well, Janet Yellen and the Federal Reserve remain committed to raising rates at the moment (albeit at a glacial pace), but Yellen noted that, “if circumstances were to change” then “potentially anything, including negative interest rates, [are] on the table.”
Not only that, but in recent stress tests, the Fed tested banks against the effect of negative interest rates, hinting that it’s certainly a possibility.

Negative interest rates explained

A negative base rate is set by central banks such as the Bank of Japan (BoJ) and European Central Bank (ECB) to stimulate growth in the economy and boost inflation.
With a negative rate in the Eurozone, for example, it now costs a financial institution like Deutsche Bank to hold their reserves at the ECB. Deutsche Bank must decide whether to pass on the negative rate to their customers or swallow the cost themselves.

Not that Deutsche Bank is on board with the decision. They called it a“catastrophic” mistake in blind pursuit of short-term stability.

The theory behind the controversial policy is simple enough. Negative rates penalize banks for parking their cash, and so they are incentivized to loan it out. By passing on the negative interest rates to the public, we are then supposedly encouraged to spend or invest, but in fact, are punished for saving.

Negative interest rates force us to move our cash into the economy, thereby pushing up growth and prices.

Of course, it’s not working.

Negative interest rates have backfired

As Japan and the Eurozone are quickly learning, negative rates don’t lift growth or boost inflation as intended. Japan’s inflation hasn’t grown. The opposite is true. As of July 2016, Japan’s economy experiences a growth rate of -0.6%, they have entered a period of deflation. This is a remarkable nose dive since December 2014, when Japanese inflation was at 2.38%. Meanwhile, the Eurozone inflation rate remains stuck at 0.2%.

Here’s why it doesn’t work:

The bank run scenario.

There’s a simple flaw in the design of negative rates. When, and if, the banks pass on the interest rate to the public, customers will simply withdraw their funds.

Since the introduction of negative rates in Japan, sales of personal safes have soared as people prepare to withdraw cash from their bank. When Switzerland first introduced negative rates in the 1970s, the amount of cash held in the economy increased enormously. Indeed, economist Larry Summers explained that if the Fed adopted a negative nominal rate, “people will choose to hoard money instead of putting it in the bank.”

It could lead to an unprecedented bank run, sparking a major disaster on Wall Street.

It’s no wonder that Sweden has all but eliminated cash from its economy. The lethal combination of negative rates and a cashless society means there’s nowhere to hide.

Decrease the likelihood of lending.

Rather than encourage banks to lend money, negative rates may have the opposite effect. Banks are reluctant to pass on the negative rate to their customers, so instead they swallow the cost of parking their money.

That eats into their profit margin, which means they are less likely to lend. When the ECB adopted negative rates, interbank lending actually dropped.

It kills government bond yields.

Over $10 trillion worth of sovereign debt bonds are now in the negatives.

The negative bond yield has halted the growth of pensions and mutual funds in the Eurozone and indeed in America. 26% of JP Morgan’s government bonds value is in the red, while Goldman Sachs recently closed their European Money Markets funds to new investors.

It increases risk and volatility in the market.

By killing the bond market, negative interest rates have eliminated one of the most liquid investment options. Bonds are traditionally used as a safe haven, but now it costs investors to use them. Instead, investors and fund managers are forced to make riskier moves to hit their growth targets.

More risky mortgages.

Negative interest rates may have the effect of payinghomeowners to take out a mortgage. It’s already happening in Denmark, and mortgage rates are close to zero in Sweden. It sounds wonderful, but this introduces yet another generation of risky mortgages. What happens if the rate rises back to 2-3%? The defaults start pouring in and it’s the 2008 crisis all over again.

Leads to a currency devaluation war.

Slashing interest rates below zero can have the effect of devaluing the host currency. The euro, registered at 1.39 against the dollar before the negative ECB rate was announced, fell as low as 1.05 last year. When central banks use currency devaluation to support their exporters, it encourages a race to the bottom.

Denmark and Switzerland, for example, both adopted negative interest rates in response to the failing Eurozone around them. They used negative rates to repel foreign currency investors who were seeking better returns from the Danish kroner and Swiss franc respectively, and forcing up their value.

It creates a domino effect. A race to devalue currency may one day force the US to slash the national rate.

There are no immediate signs that the US will adopt negative rates (yet). But keep in mind, the average German deposit holder didn’t know either. If it happens, hard-working Americans with money in the bank will pay the highest price.

Even if the US doesn’t adopt negative rates, we’re still feeling the aftershocks. Negative rates across the world crush bond returns and paralyze our pensions.

By escaping the banking system, you can reduce your exposure to the volatility and insulate yourself somewhat to the chaos of destructive central banking policies. A store of gold, held overseas (or even domestically for that matter), offers an excellent hedge against uncertainty, although in periods of deflation, gold’s value will fluctuate with the market.

Not only that, but if it’s held correctly, no one (not even the IRS) needs to know about it.

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Andrew Makarik

to@welovecostarica.com

Andrew Makarik is the main editor of WeLoveCostaRica, a fan of this sunny country. He is also a loving husband and a has a lovely daughter. By being a devoted family man and the biggest Costa Rica fan, he wants to make more people feel at home there. WeLoveCostaRica unites people and helps them find new home or a new travel destination. This website is a friendly community where everyone can find not only information, but also new friends and travel pals. Andrew is also passionate about IT and programming, so he himself maintains a friendly atmosphere in this cozy environment of WeLoveCostaRica.com.