Will the US Break This Fundamental Law of Finance? – Foreign Policy (blog)

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Economists long said it couldn’t be done. But the Bank of Japan is doing it, as are central banks in Switzerland, Sweden, and Denmark. So is the European Central Bank. And U.S. Federal Reserve Chief Janet Yellen won’t rule it out.

The “it” in question is setting negative interest rates on government bonds. This means that banks have to pay for the privilege to store money in national reserve banks, as opposed to earning interest on it. In other words, depositors are charged to save cash.

When bonds are normally bought, the issuer — whether a corporation or a government — agrees to pay the buyer interest on it. Negative rates flip the script. Investors who buy bonds with below-zero rates agree to pay the borrower to hold their money.

It’s counterintuitive, and it’s a desperate move. It means that methods like quantitative easing, when a central bank floods the market with cash, have failed to spur economic growth. Nor has setting rates at zero, making it free to borrow.

“By lowering the yields on government bonds, hopefully people will give up and start buying other things, get into riskier assets” like stocks, Angel Ubide, a senior fellow and central banking expert at the Peterson Institute for International Economics, told Foreign Policy on Friday.

Negative rates provide an incentive to spend money, not keep it locked up in a central bank. When people hold on to cash, the price of goods and services go down because demand for them lessens. This is known as deflation, something that Japan and Europe are trying to avoid. It’s bad for an economy because lack of consumer demand leads to unemployment, which further drives down costs.

Deflation fears are why Yellen refused to rule out negative rates in the United States. As the chart below shows, the cost of things in the United States is headed south.

There’s a potential downside to negative rates: People could withdraw their cash from banks rather than pay to store it. This is why economists long thought the idea was impossible.

But so far, it hasn’t happened. Most business are willing to pay a small fee to keep their money in a bank as opposed to stuffing it under the mattress. Some 40 percent of all European government bonds, worth $3.18 trillion, now have a negative yield, according to Deutsche Bank.  

It’s too early to tell if the policy works. The Bank of Japan set negative rates at the end of last month. The European Central Bank did the same in 2014.

Both continue to struggle to grow. The EU expects its economic activity to increase by 2.1 percent this year, while the IMF expects Japan’s GDP to go up 1.7 percent over the same time period.

One fear is that charging banks to store cash will hurt the broader financial sector, especially in Europe, where some bank stocks are down 40 percent year to date. However, Ubide said these fears are unwarranted because not all of reserves are in bonds with negative rates.

“To be honest, this is a high-quality problem for the banking sector. This is not going to be what makes or breaks it,” he said.

“Negative rates have been around for two or three years,” Ubide added. “I don’t hear anyone complaining too much. This is a learning-by-doing experiment.“

Photo Credit: Andrew Burton/Getty Images

Will the US Break This Fundamental Law of Finance? – Foreign Policy (blog)}