By: First Union | Date:
Should the U.S. Consider Negative Interest Rates?
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Negative rates—what does this mean and why should the US consider moving toward negative interest rates shortly?
Given the economic impact, we have seen rates near historic lows. It seems as though every week the Fed is cutting rates to try and stimulate the economy. Most recently, the Federal Reserve slashed interest rates to an unprecedented zero percent—meaning, free money essentially. Other countries similarly affected have taken it a step further and gone to negative rates. It remains to be seen if the US will follow suit, paralleling the likes of Japan, and several European nations. President Trump consequently is very much in favor of a negative rate approach. Particularly because on a global scale this country has to compete with those offering negative rates—a scenario in which the banks pay for people/companies and other such entities to borrow money.
Understanding how negative interest rates work
Most understand the concept of interest rates; it is the rate that a bank charges you when you do borrow money. When you have a negative rate, this essentially means that the central bank of a nation reduces the target rate to less than zero and so the banks then get charged for having excess money. This provides a tremendous incentive for them to lend out more and thus have less cash on hand.
From the customer's perspective, a negative rate can be a very good thing. The cost of a loan is a lot less, and in fact, it may shake out that the applicant will get paid in essence to borrow from a bank. This is not to say that customers walk away with cash per se, but rather every month when they make that payment, their debt goes down by more than what they're required to pay.
Those borrowers out there who have current loans, for instance, a mortgage or car loan, could consolidate and receive a drastically reduced rate thereby allowing them to pay far less interest over the life of the loan. They could also use the money saved to pay the debt off faster than they otherwise would have.
Now, this negative rate scenario does impact those who save money somewhat adversely. So for example, if someone has a nest egg in the bank and the country goes to negative interest rates, that person will likely earn no interest at all until rates rise again. And in some cases, they could even be charged a portion of that savings while it is in the bank.
Traditional banking redefined
If in fact, the country does opt to move in this direction, it would put a whole new spin on how we understand banking in the traditional sense. Depending on an individual's or company's situation this could be a good or bad scenario.
Generally speaking, those who manage to save are rewarded—they earn interest on accrued savings. And for those who borrow money, they are charged to do so, by way of paying interest on the amount of the loan. Once we go negative, this situation flips completely.
In other words, people would be motivated to spend and borrow as they'd earn money, and those who save would be penalized. The corresponding behavior shift would certainly be an interesting one to witness. For those looking to buy a house post-pandemic, a negative rate option is very much ideal. As people would be more hesitant to build up savings in the bank.
In light of this, there are some concerns. If people are encouraged to go on spending sprees in a manner of speaking, we are inevitably going to see fewer people with any reserves on hand should future crises arise. Additionally, people would come to rely more heavily on their credit cards and, experts suggest, over the long term this could be dangerous for many.
Most people who utilize credit cards often do so to build up credit and generally pay it off at the end of the month. However, a vicious cycle could ensue. If people aren't saving and spending higher amounts on their cards, they could rather quickly start to experience financial difficulties.
We are also probably going to be moving those avid savers out of their comfort zones—that is if they want to see an actual return on their money. They'd essentially have to look for riskier investments, and if they are not particularly high risk-tolerant, this could be quite an uncomfortable situation for some.
How likely is it that we'll see negative rates?
The burning question…will the US adopt a negative interest rate policy as several other countries around the world already have? Many financial advisors claim that going to a less than zero rate may not even work, so why risk it in the first place as it could ultimately do more harm than good. Do the risks, especially long term, outweigh any benefits? This is what many across the US government are currently trying to establish.
Banks are at stake here too. With no incentive to save their money, people will be likely to withdraw it, especially if they fear being charged to save. This in turn would seriously affect the profitability of the banking system as a whole. And in fact, it could have a reverse effect of what is intended in that banks could have to tighten up lending restrictions.
Not to mention, it isn't addressing the crux of the problem. The virus put many out of work, zapped the nest eggs of thousands if not more; people aren't necessarily looking for more money to buys cars when they're just struggling to get by.
That said, many believe that there is a real possibility the US will implement negative rates. First, though, a thorough economic picture needs to be painted and the risks versus benefits most definitely weighed.