Negative Interest Rates: The Fed Might Do the Unthinkable

Rodney JohnsonSailing can be exhilarating. A 20-mile-per-hour wind pushes everything – crew, boat, sails, hardware – to the limit.

But there are other days when the breeze simply dies. If you’re out for a leisurely sail, then no problem. Just crank up the engine. However, if it happens during a race, you can find yourself sitting dead in the water, or worse… going backward with the tide.

A friend of mine was in this exact situation when the skipper called on the crew to lower the anchor. As they scurried about the deck appearing to look busy with the sails, the other boats slowly slipped behind them, floating backward.

In a sense, my friend’s boat gained ground by going nowhere.

The Fed governors have done the same. For all of their talk, they’ve moved ahead by not floating backward with the pack.

Over the last two years, four central banks in Europe did something that was once unthinkable. When their zero interest rate policy (ZIRP) didn’t work, they went lower. They moved interest rates into negative territory, introducing a negative interest rate policy (NIRP).

The European Central Bank (ECB), along with the central banks of Sweden, Denmark, and Switzerland, all charge large depositors to hold cash.

This might seem backwards, because it is. Theoretically, depositors who don’t want to pay the fees could withdraw all of their cash from banks, thereby escaping them.

But that doesn’t work in the real world.

While the average Joe might be able to shut down his checking account, it’s a bit tougher for IBM, Caterpillar, or New York Life Insurance to do the same thing.

Cash management is a multi-trillion dollar industry. Huge sums are moved daily to meet endless obligations, from payroll to bond payments. There’s no way for entities as large as these to avoid, or even minimize, their interactions with the banking system.

So, even though it flies in the face of the modern banking relationship, they pay the fees.

This is not normal. Ordinarily, deposit institutions take cash from clients, pay them interest, and then lend the money at higher rates to borrowers.

Today, banks can’t find enough borrowers. The cash sits unused on their books, collecting dust and costing the banks money. The negative interest rates are supposed to motivate those holding cash to lend it or spend it, thereby driving economic activity.

But without great investment prospects or quality borrowers, there’s no reason to do either. Instead, they hold onto the cash, confident that low inflation or even deflation will keep prices in check so that the cash won’t lose too much value.

While European central banks toy with the unthinkable, on this side of the pond, Fed governors keep sparring over when to raise rates from zero.

They go back and forth over employment and inflation figures, trying to parse out current trends. If the economy is improving, then raising rates now would nip potential inflation before it starts. It would also provide the Fed with some much-needed room for lowering rates in the next downturn.

Interestingly, by doing nothing, the Fed has achieved most of what it wants. Compared to other currencies our rates are high, which attracts depositors, strengthens the U.S. dollar, and taps the brakes on the economy.

So while zero interest might not sound like much, compared to what depositors earn in other countries, it’s a windfall!

The difference grows wider further out on the yield curve. The 10-year U.S. Treasury bond yields around 2.0%. The German 10-year pays a mere 0.5%, while those buying Swiss 10-year bonds must pay the government because the yield is -0.3%!

Looking across our economy, companies are telling the Fed that they feel the pain. Quarterly profits and revenue are set to decline together for the first time since the financial crisis. Earnings are expected to decline by 2.8% for the third quarter and sales, which have been falling all year, are expected to drop by 4%.

Hit by a double whammy of the collapsing energy sector and falling exports, big companies are crying uncle. None of this screams that economic growth is so strong it must be reined in. If anything, it looks like the start of the next downturn is just ahead, if not already underway.

That makes the most likely course ahead not for higher rates, but for the Fed to raise its anchor off zero, and at some point start slipping backward with the rest of the fleet.

Rodney Johnson

Rodney

Follow me on Twitter @RJHSDent

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Categories: Interest Rates

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.