Why The US Should Avoid Negative Interest Rates
The United States appears to be headed toward recession. Forecasts predict the weakest global economy since 2008, and investors are scared that the US will follow. The US and China have yet to reach a satisfactory agreement to end their trade war. At the same time, Germany appears to be on the cusp of a recession while Brexit shrouds Europe in economic uncertainty. The US economy grew at a slower rate than normal in the last quarter, and industrial production is declining. Tepid economic growth combined with an already low US interest rate has inspired talks about negative interest rates to encourage investment and reduce savings.
The European Central Bank decided to set a negative target interest rate to induce more spending. This policy makes the Euro relatively cheap compared to the dollar. As a result, President Trump has called for a negative interest-rate target in the United States to compete with European prices and spur economic growth. The negative rate would force banks to lend more through penalty payments on their reserves. Negative rate targets may seem like good policy given the relative stability of European economies after the ECB set a -0.5% rate. However, economic theory implies that the US should be cautious with the policy.
Low interest rates are designed to increase investment or to reduce saving to increase aggregate demand. However, there is reason to believe negative interest rates will not have the same effect. If the Fed sets a negative interest rate, firms will shift from equity finance to cheaper loan finance which induces them to return equity to shareholders and adopt riskier balance sheet financing structures. Simultaneously, firms will reduce money holding and increase capital investment and holding of Nonrefundable Assets (NRAs). This process will continue until the marginal efficiency of investment reaches zero where firms will substitute all investment for NRAs. Hence, a negative interest rate will not increase investment in the long-run.
Rather than reduce savings, a negative rate would likely have ambiguous effects. The rate would incentivize less spending and higher consumption, but would also lower future income and total income through the life cycle- which conversely induces greater levels of saving to smooth consumption. These effects deliver ambiguous levels of saving in the economy. Therefore, a negative interest will only reduce savings in some cases while increasing it in others.
Europe is just beginning to see the impact of negative rates. Deutsche Bank estimated that lenders have lost ~8 billion Euros a year since the policy began. There are claims it has weakened European banks and fueled a surge in corporate debt and asset prices. The United States Fed should not set a negative interest rate target. Rather policy makers should seek to solve structural problems of inequality and chronic trade deficits. Negative interest rates pose too great a risk and only push the US’s economic maladies into the future.
Some Sources
http://web.a.ebscohost.com/ehost/pdfviewer/pdfviewer?vid=2&sid=2e9c5e09-3939-4d24-8008-cdd176dead08%40sessionmgr4006
https://www.washingtonpost.com/opinions/should-we-love-or-hate-negative-interest-rates/2019/09/15/70536a50-d64c-11e9-9343-40db57cf6abd_story.html
https://www.marketwatch.com/story/why-would-the-fed-cut-interest-rates-a-3rd-time-in-a-row-even-as-stocks-near-records-investors-may-soon-find-out-2019-10-27
https://www.nytimes.com/2019/08/15/business/economy/central-bank-rate-cuts.html
https://www.reuters.com/article/us-usa-trump-fed/give-me-some-of-that-trump-renews-call-for-negative-u-s-interest-rates-idUSKBN1XM2B7
https://www.forbes.com/sites/randybrown/2019/11/12/we-shouldnt-fear-a-global-recession-just-yet/#56babea84644
https://www.bloomberg.com/news/articles/2019-07-17/europe-dived-into-negative-rates-and-now-it-can-t-find-a-way-out
https://fortune.com/2019/10/04/what-is-a-semi-recession-2019-2020/
The European Central Bank decided to set a negative target interest rate to induce more spending. This policy makes the Euro relatively cheap compared to the dollar. As a result, President Trump has called for a negative interest-rate target in the United States to compete with European prices and spur economic growth. The negative rate would force banks to lend more through penalty payments on their reserves. Negative rate targets may seem like good policy given the relative stability of European economies after the ECB set a -0.5% rate. However, economic theory implies that the US should be cautious with the policy.
Low interest rates are designed to increase investment or to reduce saving to increase aggregate demand. However, there is reason to believe negative interest rates will not have the same effect. If the Fed sets a negative interest rate, firms will shift from equity finance to cheaper loan finance which induces them to return equity to shareholders and adopt riskier balance sheet financing structures. Simultaneously, firms will reduce money holding and increase capital investment and holding of Nonrefundable Assets (NRAs). This process will continue until the marginal efficiency of investment reaches zero where firms will substitute all investment for NRAs. Hence, a negative interest rate will not increase investment in the long-run.
Rather than reduce savings, a negative rate would likely have ambiguous effects. The rate would incentivize less spending and higher consumption, but would also lower future income and total income through the life cycle- which conversely induces greater levels of saving to smooth consumption. These effects deliver ambiguous levels of saving in the economy. Therefore, a negative interest will only reduce savings in some cases while increasing it in others.
Europe is just beginning to see the impact of negative rates. Deutsche Bank estimated that lenders have lost ~8 billion Euros a year since the policy began. There are claims it has weakened European banks and fueled a surge in corporate debt and asset prices. The United States Fed should not set a negative interest rate target. Rather policy makers should seek to solve structural problems of inequality and chronic trade deficits. Negative interest rates pose too great a risk and only push the US’s economic maladies into the future.
Some Sources
http://web.a.ebscohost.com/ehost/pdfviewer/pdfviewer?vid=2&sid=2e9c5e09-3939-4d24-8008-cdd176dead08%40sessionmgr4006
https://www.washingtonpost.com/opinions/should-we-love-or-hate-negative-interest-rates/2019/09/15/70536a50-d64c-11e9-9343-40db57cf6abd_story.html
https://www.marketwatch.com/story/why-would-the-fed-cut-interest-rates-a-3rd-time-in-a-row-even-as-stocks-near-records-investors-may-soon-find-out-2019-10-27
https://www.nytimes.com/2019/08/15/business/economy/central-bank-rate-cuts.html
https://www.reuters.com/article/us-usa-trump-fed/give-me-some-of-that-trump-renews-call-for-negative-u-s-interest-rates-idUSKBN1XM2B7
https://www.forbes.com/sites/randybrown/2019/11/12/we-shouldnt-fear-a-global-recession-just-yet/#56babea84644
https://www.bloomberg.com/news/articles/2019-07-17/europe-dived-into-negative-rates-and-now-it-can-t-find-a-way-out
https://fortune.com/2019/10/04/what-is-a-semi-recession-2019-2020/
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