What Happens When Interest Rates Are Negative?

The unimaginable is already happening in several countries in Europe and Asia.

Happy Friday morning everyone! I hope you all had a fun Halloween and are prepared for the rest of the holiday season. Winter is already here for some of us (including me). Today’s topic is interest rates, which seem to keep dropping in the U.S. and around the world. But can interest rates just keep going down forever? Read on to find out…

Can you imagine paying your bank interest to keep your money? Or buying a home and taking out a mortgage and paying no interest, or even paying less than you actually owe? This is the reality in several countries in Europe, including Germany and Switzerland, that have negative interest rates as low as -0.75%. Japan has also gone negative at -0.10%. Interest rates in the U.S. have always been positive, but are at historically low levels. The Federal Reserve is on a streak of cutting interest rates, and the President is a big fan of interest rate cuts, calling the Federal Reserve ‘boneheads’ for not resorting to negative rates in the U.S.

Negative interest rates are a foreign concept to most U.S. consumers, but they are what they sound like: you pay the bank to hold on to your money. They also defy logic; when you lend someone money, they should pay you a penalty for borrowing that money. Economies across the world have operated on that concept for centuries, but we appear to be turning a corner in global interest rate policy. No one really knows if we are turning the page of a horror novel and are headed for chaos or if we are promoting prolonged economic growth by having really low interest rates.

Why does the President love interest rate cuts so much?

Donald Trump is a big fan of interest rate cuts. He’s not afraid to tell the Fed to lower the interest rate to ‘zero or less,’ and he’s been unhappy with the, in his mind, inadequate, interest rate cuts we’ve seen so far. So why is he such a big fan of interest rate cuts? It’s pretty simple: lowering interest rates stimulates the economy. With lower interest rates, people are more likely to take out loans to start a business, buy a car, buy a house, you get the picture. 

Negative interest rates would also weaken our currency, which would make our exports cheaper (for other countries to buy) and more competitive in the global economy. It would also make imports more expensive. Considering Trump’s push to bring manufacturing jobs back to the U.S. and to have more goods made in America, lowering interest rates and devaluing our currency is consistent with his economic goals. Devaluing currency might not be such a great idea, as it could lead to a currency war, or essentially a race to the bottom, which would be good for no one. If our currency is worth less, we would also not be able to spend as much in other countries or buy as many goods from other countries, which might be what Trump wants.

What do negative interest rates mean for consumers?

If interest rates went negative in the U.S., consumers and businesses would be more inclined to take out loans. Imagine buying a house, taking out a mortgage, and never paying any interest. There would also be negatives; banks probably wouldn’t make interest rates negative for savings accounts and checking accounts, but interest rates would be zero or close to zero. Banks would introduce new fees for checkings and savings to make up for the money lost on negative interest rates, which might encourage consumers to not use banks at all. 

What’s going to happen if we enter a period of recession with negative interest rates?

Right now, traditional economic indicators say the U.S. economy is doing pretty well. We have historically low unemployment, consumers are spending money, and houses are being built. Interest rates are usually lowered when the economy isn’t doing so well. So what is going to happen if interest rates keep getting lower and lower and we enter into a period of recession?

Interest rate cuts are kind of like a drug that stimulates the economy. The U.S., and the rest of the world, is addicted to economic growth. Interest rate cuts and currency devaluation are part of the fuel that leads to economic growth. Usually when the economy is doing well, interest rates (and inflation) are higher; when the economy starts contracting, interest rates are lowered. The world has become so addicted to economic growth that we are now seeing low interest rates and currency devaluation even when times are relatively good. If we enter a period of recession and interest rates are already very low or negative, there might not be any room to make further cuts. 

This could be problematic. If we enter a recession with already low interest rates, do rates get cut more? Is there a limit to how low interest rates can go? There is going to be a breaking point, we just don’t know where that point is at. We’ve never seen negative interest rates before, so part of the world is already in uncharted territory. At some point, something in the financial system is going to break. Interest rates can’t keep going down forever. If interest rates get low enough and banks charge people to keep their money in a bank, people might start keeping all their money under the mattress, or convert all their fiat currency to cryptocurrency. 

The interest rate’s connection to the unemployment rate

Lower interest rates usually mean lower unemployment rates. With lower interest rates, companies are more likely to take out loans to expand their businesses, and people are more likely to take out loans to start new businesses. As you can see in the chart below, unemployment in the U.S. is currently at historically low levels.

Unemployment never stays at historically low levels for very long, though. If you notice in the chart, the unemployment rate has a history of spiking after a short period of very low unemployment. The unemployment rate in the U.S. doesn’t have much further to drop. If history is any indication, we could soon enter into a period of higher unemployment, and potentially a period of recession.

The government will attempt to maintain our historically low unemployment rates with interest rate cuts and other fiscal and monetary policy, but we don’t really have much lower we can go.

Does this mean a recession is imminent?

When comparing where we’re at now to historical trends, it’s pretty likely that we’ll enter into a period of recession in the next several years. Although recession is a scary word, it’s important to remember that recessions can be mild.

When it comes to investing, it’s best to keep your long-term goals in mind and not overreact to changes in the economy. Many Americans pulled their money out of the stock market at the height of the recession in 2008 and 2009 and have never fully recovered. Disciplined, systematic investing (also called dollar cost averaging; this means putting money into the market on a consistent basis, usually monthly) can be a great way to combat market volatility.

Volatile economic and political times are frightening, but it’s important to stay the course and remain laser-focused on your long-term goals.

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