The US Federal Reserve cut interest rates on July 31, 2019. This was the first rate cut since the 2007-08 financial crisis. In the latter part of 2019, with inflation at bay, the Federal Reserve has changed its stance from hawkish to dovish. In other words, the Federal Reserve now prefers lower interest rates, which makes consumers more likely to borrow and spend money, which encourages economic growth. The Fed’s policy interest rate is currently set in a range of 1.75 to 2 percent. When you look at the federal fund’s rate for the past 60+ years, this 2% interest rate looks extremely low.
The reason why some people see the Fed’s 2% interest rate as “high” is due to the negative interest rates prevalent in other developed regions of the world. Japan, Denmark, Sweden, Switzerland, and the European Central Bank are some of the developed regions that offer negative interest rates. Due to globalization, the economic growth of a country can technically be affected by the monetary policies of other counties. I do not think that the US Federal Reserve would ever push interest rates in the negative territory, but we can talk about how negative interest rates work in this blog post. Let’s dive in.
Negative interest rates refer to a setting when you get an interest payment from the financial intuition for taking out a loan, and you have to pay the bank a storage fee for your cash deposit (savings) at the bank. Simply put, everyone is incentivized to borrow and spend as much money as possible. Sounds like a reckless way of living, right? So, why does the European Central Bank (ECB) have negative interest rates?
In February 2015, Eurozone’s inflation rate dropped in the deflationary territory at -0.6%, and ECB policymakers decided to do whatever it takes to avoid the deflationary spiral. The 2 ways to fight deflation is by “printing money” and lowering interest rates. The ECB started its Quantitative Easing (printing money) program in 2015, and pushed the interest rates farther in the negative territory. The negative interest rates were set at -0.4% on bank deposits for 17 euro-zone counties until September 2019. As of October 2019, the ECB interest rates are at -0.5%. What was the reason for additional rate cut? To lower the value of Euro, which would increase the demand for exports, and encourage businesses to grow. Negative interest rate environment is an uncharted territory for all countries.
Although the end goal of negative interest rate environment is to have citizens spend rather than save (which helps economy grow), there are many ways in which this easy lending could backfire. For example, since home mortgages are linked to interest rates, banks would be less likely to lend out money during negative interest rate environment as it would squeeze the bank’s profit margin. Additionally, banks would be hesitant to drop interest rates on their bank deposits below 0% because individual investors are likely to make a run to the bank and start hording cash instead of paying a storage fee.
The biggest question I have is: how would any country go back from negative interest rates to positive interest rates environment without causing a contraction in the economic growth? Negative interest rate environment just seems like this black hole, which can be entered easily, but it is nearly impossible to escape. The only times when a country would increase interest rates is when its economy is booming and there is growing inflation in sight. However, it has been 4 years since the ECB pushed the rates in the negative territory and the ECB has not seen any major benefits from it. In fact, the European economy is not growing – Germany, euro-zone’s largest economy, seems to be at the brink of a recession. So, the ECB will likely have to go deeper into the negative environment before even thinking about coming to the positive side.
Negative interest rate is a slippery slope. I would prefer an economy to go through a short term economic cycle, rather than pushing the can down the road and making the downturn bigger and more devastating in the future. When the next recession hits Europe, I wonder how much in the negative territory will the ECB have to drop the interest rates to help stimulate economic growth?
Hope you learned a little and found this blog post helpful. We talked negative interest rate environment, and the current events associated with it. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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