Why So Negative?

Imagine depositing your cash in a savings bank and being told that you will receive no interest on your money and, instead, must pay a fee for the luxury of keeping it in the bank. Crazy right? Economists once thought that the lower bound of interest rates was zero, but Central Banks in Europe and Japan are now paying negative rates on bank deposits, which in some cases are being passed on to individual depositors.

Why not just keep your cash under the mattress or in a safe? According to a recent Wall Street Journal article, sales of safes in Japan were 2.5 times higher in February than in the same period a year ago. The Bank of Japan introduced their negative rate policy at the end of January. In countries with negative interest rates there is growing evidence of cash hoarding, particularly in large denominated bills. But the craziness doesn’t end there.

The Financial Times published a story recently suggesting that helicopter drops of cash might be needed to address weak economic demand. The reference is to an idea from Milton Friedman, Nobel Prize winner in Economics, who used the imagery to underscore the urgency of stimulating consumer demand and returning inflation to some modest level when the threat of deflation is present.

While the United States flirted with negative interest rates in the aftermath of the financial crisis, it is a rarely observed phenomenon. How did we get here? Interest rates and inflation generally reflect expectations for future growth and price levels, so the low rate environment since the crisis is not surprising. The story gets a little more complicated when growth is so low that inflation turns to deflation. In a deflationary environment, prices are declining so buyers defer purchases and, in so doing, depress current growth even further and set the stage for further price declines. Economists refer to this as a deflationary spiral, which once started, can have a devastating impact on an economy.

Former Federal Reserve Chairman Ben Bernanke, a student of the Great Depression, knew all too well the risks of deflation. That’s why the Federal Reserve maintained low-interest rates for such an extended period of time and why it felt the need to jump-start the economy with successive rounds of quantitative easing (QE). In the absence of a fiscal stimulus program there were few alternatives to increase economic demand.

All else being equal, interest rate declines may weaken currency prices and thereby stimulate exports. But stimulus through exchange rates becomes a zero sum game if every central bank deploys the same strategy. Last week, Mario Draghi, Head of the European Central Bank, cut the deposit rate to minus 0.4 percent and offered to pay negative rates on long-term loans to banks – essentially paying lenders to increase credit to households and companies. He added that interest rates would stay low for “an extended period.” Sound familiar?

Many financial experts worry that we are testing the limits of QE. Without an increase in real economic demand, the kind that might come from fiscal stimulus, i.e., increased spending or reduced taxes, the threat of recession will continue to overhang the markets. The only problem is that in the absence of a crisis, legislators seem incapable of agreeing on what that policy should be. Perhaps the economy’s best hope rests on the principal that a double negative, stylistically speaking, still leads to a positive.

Categories: MBA