How Negative Interest Rates Work (And What They Would Mean for the Economy)

in September of 2019 US President Donald Trump posted a strange tweet that started with the following sentence the Federal Reserve should get our interest rates down to zero or less and we should then start to refinance our debt the u.s. is no stranger to low interest rates after the 2008 financial crisis the lower band of the federal funds target rate hit zero percent but never before has the US had negative interest rates now if you're anything like me when I first heard of negative interest rates you may have a hard time wrapping your head around the concept in what universe does a borrower get paid for holding a loan well it's something that's already been implemented in Europe and Japan but it stands as a drastic step for the US economy and if the president is looking to implement these rates it's probably worth going over the concept so let's discuss negative interest rates and what they would mean for the economy on todays plain bagel before we talk about negative interest rates let's discuss the system as it currently stands interest rates are of course the percentage of a loan that you pay to a bank as a fee for borrowing from them they're also the rate that you receive for saving your money when you deposit said money in a savings account with a financial institution though the two rates probably won't equal one another a normal interest rate will cost people for borrowing and reward people for saving straightforward enough right now just like URI banks have their own deposits the deposit or lend their money to other banks on the overnight market and can choose to hold more than what's required of them under US law at the Federal Reserve the US central bank these deposits provide them interest the rate they receive on deposits with other banks is known as the federal funds rate which is a market determined rate and the rate for deposits at the Fed is known as the interest on excess reserves rate the Federal Reserve uses the IO er to change the federal funds rate since they can't control the rate directly and the two are closely tied to one another now when the economy is weak the Federal Reserve will lower its ioe AR which in turn should bring down the federal funds rate as a way to discourage banks from saving their money and to encourage them to lend it out as a way to boost business activity but what happens when the Federal Reserve pushes its rate below zero well banks would begin losing money on their deposits and in theory a negative IOA r would lead to a negative federal funds rate meaning that banks would also charge one another for holding their money on the overnight market this will trickle down to affect all other savings accounts within the economy a negative interest rate will likely mean consumer savings accounts will have their returns plummet to zero and these accounts may also experience a negative interest rate since a bank will be paying to hold the money you deposit with them though banks may choose to simply absorb the cost to keep customers who may purchase other products like insurance financial instruments things like that either way consumers will be discouraged from holding money in savings accounts in with both banks and the average person being incentivized to use their cash we could see heightened business activity as both parties increases spending investing and lending which is clearly the intent of such a move but this brings us to an interesting point what do negative interest rates mean for loans will banks and consumers be paid for borrowing money well yes maybe no it depends if the lowered ioe our rate were to bring about a negative federal funds rate as it should in theory it would mean that banks would earn money when they borrow on the overnight market so a bank could effectively borrow $100 and only pay back 99 dollars and change the next day talk about a great deal but why would a lending bank ever agree to a negative interest rate loan well they may not but barring any regulatory requirement forcing them to keep cash in the system the simplest explanation for why we might still see activity here is that the cost of holding cash may outweigh the fee of leaving the money with someone else even if you have to pay them since holding an excessive amount of money could increase security fees wages and even regulatory costs it might make sense for a bank to leave the money at another institution but banks use in the overnight market are borrowing money for less than a day and the fees may be negligible if banks frequently switched between lending and borrowing as they tend to do whether consumers will be able to borrow at a negative interest rate loan is a different matter firstly when it comes to consumer loans commercial banks will always charge an interest rate that is higher than what they pay for their own loans that is after all how they make money if they can borrow for two percent they'll charge you four percent and if they can get a loan that pays a zero point five percent negative rate they may still charge you a positive one point five percent so while interest rates would fall they may not necessarily fall into the negative range for consumers though it is possible and in fact we've already seen it in Denmark not too long ago a Danish bank was offering a negative 0.5 percent mortgage mean you could buy a house and eventually pay back less than what it costs you exciting right well it shouldn't be well being paid to borrow may sound great incredible actually we still don't fully understand all the ramifications of negative interest rates theoretically it all makes sense negative interest rates would boost investing in lending which in turn would cause inflation inflation or rising prices would mean the value of the dollar false which would make us Goods cheaper to foreign countries providing another boost to demand for goods and services these are all things that should increase business activity employment wages all that good stuff but is that what will actually happen well maybe not indeed we've seen negative interest rates imposed by the eurozone Denmark and Japan among other countries but these places struggled with chronically slow growth in deflation when prices fall deflation can be bad as it encourages banks and consumers to hoard their money rather than spend it since a dollar tomorrow will be worth more than a dollar today this can lead to a vicious cycle and prompt further declines in spending and more deflation so negative interest rates were seen as a way of discouraging this in encouraging spending and yet these places still experience low inflation and slow growth despite the negative rates on top of this there are a number of ways in which negative rates could backfire negative rates could cause a run on the banks if people opt to physically store their cash rather than keeping it at the banks and paying a fee for it we could also see runaway inflation and even an asset bubble if mortgages offer negative rates people may begin buying up housing prices to unsustainable levels so it might not even be easier for you to afford a house negative rates would also hurt savers and income investors as it would mean receiving a low to no yield on bonds or other income instruments in other words those with low risk tolerances may be forced into riskier positions just to maintain their wealth negative rates would also squeeze profit margins for the banks since again they will need to pay for their deposits at the central bank and interestingly enough some research suggests that this has actually decreased lending activity in countries that implemented negative rates since it hurt the banking profits and discouraged lending activity as a whole but one of the more certain consequences of implementing negative rates now is that it would take away an important lever for the central bank in an actual downturn as of right now employment in the US is high inflation is close to target and earnings growth while it is slowing is still healthy certainly not the scene faced by the eurozone Denmark and Japan yes we may see a recession but there are no indicators of a pending crisis and if the US were to implement such a drastic measure as negative interest rates to boost the economy and then later experience something like the 2008 housing bubble the interest rate tool would be largely spent debt would be even higher than what it currently is it would could be in for a disaster so that's a controversial and paradoxical negative interest rate explained it's something we still don't fully understand given the small sample size of countries implementing it and the mere decade's worth of data sure as Trump tweeted low interest rates may allow the US government to refinance at a lower rate but even that may not pan out as expected Germany a country with negative rates was recently unsuccessful in raising two billion euros worth of its negative yield government bonds only raising 824 million at the end of the day monetary policy can only do so much in negative rates should be treated as the dangerous and desperate tool it is after all there is no free lunch in the world of economics and the potential hit to the integrity of the US dollar the economy and of course the independence of the Federal Reserve may all well outweigh the benefits of a negative interest rate shift thanks for watching if you liked this video make sure to hit the like button if you liked we're doing here make sure to subscribe hit the bell icon if you want notifications about future videos if you have any feedback or topics you want me to cover in a future video leave a comment down below for the plain bagel my name is Richard coffin thanks for joining me today [Music] [Music]

Channel: The Plain Bagel

Views: 476,425

Keywords: The Plain Bagel, Negative Interest Rates, Federal Reserve, Trump, Negative Interest Rates Explained

Id: pX3_3NMZa0k

Length: 9min 20sec (560 seconds)

Published: Fri Oct 04 2019