Over the last decade, low-interest rates have been a commonplace monetary policy throughout the globe. Keeping interest rates low played an important role in helping the economy recover from the 2008 financial crisis. However, cutting interest rates below zero is not a conventional monetary policy.
Negative interest rate policy (NIRP) has been introduced by foreign central banks such as the Bank of Japan in 2016 and the European Central Bank in 2014. The idea behind introducing negative rates is to help stimulate stagnant economies and prevent a deflationary spiral which causes the price of goods to plummet.
Why Negatives Rates Are Bad
Due to the downsides that come with negative interest rates, the unorthodox policy is bad for investors. Traders will have a difficult time keeping saved cash protected from negative interest rates. Investing in government bonds that offer a positive return will be next to impossible.
Animosity towards financial institutions and the global financial system will grow if more countries push rates below zero. And central banks will be left nearly defenseless against recessions if rates are already negative.
Let’s go over these four effects of NIRP in more detail and why the policy is undesirable for investors.
Savers Will Pay
Negative interest rates punish savers and encourage poor financial habits. In a negative rate environment, banks charge consumers to keep their cash in a bank account. Your hard-earned money will begin to diminish if you decide to save it instead of spending it.
Getting charged to save money discourages people to save and develop good financial habits. Workers are already paying taxes and paying for the rising costs of living. Having additional money stripped from your paycheck is very disheartening.
Savers may decide to invest more of their money but will be forced to take on unnecessary amounts of risk. Investing funds meant for emergencies or significant purchases such as a home or car usually ends badly due to unforeseen market fluctuations.
If people can’t even find a safe place for an emergency fund, how will they be able to save enough for investments? Society will be more likely to spend their money unnecessarily, which can result in widespread financial recklessness.
Investors will lose money on negative-yielding bonds. Bonds are a common financial instrument used by investors to diversify their portfolio and lower their risk tolerance. One of the most popular and safest forms of bonds are government bonds. When a negative interest rate policy is put in place, the yields for government-issued bonds turn negative as well.
The phenomenon of negative-yielding bonds is already taking place in both Europe and Japan. European bond investors have a rough road ahead of them.
The Wall Street Journal reported that “European bond investors are hamstrung by their home markets, where negative-yielding debt has upended the basic math of money-making.” Investors in Europe and Japan do not have much of a choice and will purchase money-losing bonds to keep their money safe or avoid even worse yields.
Kevin Zhao, lead manager of the UBS Strategic Bond Fund at UBS Asset Management. Keven stated “Monetary policy has reached its limit in the eurozone, the ECB has very limited power,’’ He recently cut his position on Treasurys and is shorting government bonds from Germany, Sweden, and Switzerland.
More investors are likely to follow suit and decrease their position in bonds, take on more risk and even short sell government bonds. Negative interest rates make it harder for investors to properly diversify and find safe returns.
Distrust in the Financial System
Negative interest rate policy increases distrust in financial institutions and central banks. If more countries continue to incorporate negative interest rates it makes it appear that things are not okay. People will increasingly worry that something is seriously wrong with the world’s financial system.
Negative rates make investors more reluctant to invest when central banks are taking desperate measures to stimulate the economy. The status of the economy will be in a place of severe uncertainty. Society will begin to lose faith in their once trusted banks. People would rather not pay them to keep their money and decide to hoard cash instead.
If everyone chooses to pull their money out of the financial system (known as a bank run) it can lead to a financial collapse.
Germany is a good example of how negative interest rate policy can have adverse effects on the publics’ trust in financial institutions. The country’s citizens are known for being avid savers, and Germany is home to one of the largest number of deposits in the euro area.
Citizens of Germany have not been welcoming to the introduction of negative interest rates. Thomas Escritt and Francesco Canepa (2019) further described the manner once Germany appointee to the board of the European Central Bank resigned after policy backlash: “Frustration at the central bank’s easy-money policy of sub-zero rates and massive bond buys is running high in Germany, with tabloid Bild depicting ECB President Mario Draghi as a vampire sucking off Germans’ savings.”
It’s easy to imagine how bad the backlash the Federal Reserve would receive if they decided to push interest rates below zero in the United States.
What’s Next After Negative Interest Rates?
Central banks that have already implemented a negative interest rate policy will be unable to effectively help the economy recover when a recession comes. In the past, central banks have lowered interest rates to help spur economic growth during a recession.
If interest rates are negative and a recession hits, banks are left with little options to combat economic declines. This has already caused some serious concern in the United States.
Starting in 2019, the Federal Reserve has been cutting interest rates and injecting money into repo markets while the market is at all-time highs. It’s left many wondering what can be done when the US is faced with its next recession.
Without any conventional monetary policy left to use, central banks will continue to push into uncharted territories, like making interest rates negative.
Negative interest rate policy was created to reduce deflation by encouraging consumers and corporations to borrow and spend money. It’s a relatively new policy that has been used somewhat sparingly so far. It is beginning to gain more traction and it’s hard to tell exactly how bad the repercussions of its use will be.
We do already know the ill effects it has had in both Europe and Japan. Savers will have to pay if they want to continue saving their money in a bank account. This will cause more people to spend than save. Bondholders will lose money and have an extraordinarily difficult time finding safe returns. Investors may decide to stop buying government bonds altogether.
Society will have increased distrust in the financial system and decide to hoard cash instead. If more people hoard cash, the possibility of bank runs will rise. Once a recession or economic decline hits a country with negative rates, central banks will have already used all their ammo for fighting recessions.
Without a way to spur economic growth, a normal recession can turn into a severe economic decline or worse a depression. Overall, a negative interest rate policy is bad for investors. Only time will tell just how bad it will be if the policy is implemented in the US.