Negative Interest Rates: An Interesting Revolution
August 15, 2016
Consider a world where you can earn a higher return stashing your money under your mattress than you can at your local bank. Now this might seem strange because your mattress provides a rate of return of 0% but as banks around the world begin offering negative interest rates, 0% may start looking comparatively good.
Due to the extended period of minuscule interest rates, central banks no longer have a wide range of tools to use as part of their monetary policy. Central banks generally reduce interest rates to stimulate borrowing and lending and to increase economic activity, but sometimes reducing the rate to zero simply isn’t enough.
In order to incentivize banks and businesses to spend their money, a central bank can begin to charge negative interest rates. Similarly to how regular people deposit money at their local banks, commercial banks deposit some of their money with the central bank. A volatile global economy over the last few years, punctuated by things like the recent Brexit (see Brexit Basics), has resulted in a number of central banks around the world beginning to charge commercial banks fees for holding their money. This is a negative interest rate.
In times of uncertainty, people have a tendency to hold onto cash and keep their head down until things clear up. The purported benefit of negative interest rates is that it will force banks and businesses to spend more freely and use up excess cash that would otherwise cost them a fee.
There are a number of costs to negative interest rates though. For starters, they are an economic unknown. In the history of modern banking there has never been a period of negative interest rates and some economists argue that it shouldn’t even be possible lest there be a devastating run on banks. Alternatively, banks may be reluctant to pass along the negative rates to customers in fear of such a run which could lead to lower profits and capital erosion, damaging important financial institutions necessary for economic growth.
What is a regular person like you and I supposed to do if interest rates become negative? Invest! Why let your hard-earned capital slowly decompose from bank fees, not to mention inflation, when you can invest and take advantage of the potential recovery? Instead of hiding your money under the mattress you should be investing in a diversified portfolio; ensuring that even when the world is negative, you still have the opportunity to see a positive return.