There Are Plenty of Negatives with Negative Interest Rates | Capital Group

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There Are Plenty of Negatives with Negative Interest Rates 

Of all the unlikely occurrences in the financial markets recently, none may be more surprising than the emergence of negative interest rates. For years, negative rates were thought to be impractical and perhaps even impossible. But given the inability of other measures to spark lasting growth, central banks in Japan and Europe have turned to negative rates in hopes of jumpstarting their plodding economies. It’s doubtful the U.S. will go this route because the domestic economy is in comparatively solid shape. Nevertheless, the negative-rate policies of other countries are pushing the boundaries of monetary policy with potentially adverse consequences.

“Negatives rates distort the natural flow of capital throughout the system,” says David Hoag, a fixed-income portfolio manager at Capital Group Private Client Services. “These policies penalize savers, robbing them of the income they need from savings, and direct capital to what may be unproductive areas of the economy. For economies to function normally, they need positive interest rates and they need capital to be allocated efficiently.”

To understand negative rates, consider how lending works in normal times, with banks paying interest to depositors while charging interest to borrowers. The opposite essentially takes place with negative rates, as banks charge depositors. At the moment, this dynamic primarily applies to commercial banks, which keep funds on deposit at central banks. Rather than earning interest on that money, as they typically do, commercial banks are effectively paying central banks to hold their cash.

The goal is fairly simple — to discourage commercial banks from stockpiling cash. By imposing what is essentially a tax on deposits, central banks are trying to prod commercial banks to increase lending and investment. In theory, that should boost inflation and economic growth as the money is ultimately put to use by businesses and consumers.

However, that’s unlikely to play out in reality. “What really needs to happen is for governments to implement fiscal reform and stimulus for these economies to turn,” Hoag says. “It means embarking on large infrastructure projects as well as creating tax and regulatory environments that encourage economic growth. But given the political difficulties, this will happen slowly and in fits and starts.”

One risk of negative rates is that they could cause bank earnings to fall sharply as profit margins get squeezed. Far from spurring additional lending, that could further dampen economic growth by prompting banks to rein in credit to preserve their capital. Beyond that, the very existence of such unorthodox monetary policy can exacerbate economic jitters by making corporate executives reluctant to borrow and spend. Finally, negative rates can unleash inflationary pressure. Though loose monetary policy has not had an impact on consumer prices, it has significantly pushed up values of financial assets and high-end goods such as luxury homes.

Thus far, the most immediate impact of negative rates has been a lowering of bond yields, including those of Treasury securities as foreigners seek the relatively high yields available in the U.S. That has suppressed yields on other types of debt such as mortgage rates and car loans, but it has penalized savers.

Despite the risks, negative rates are likely to remain in place for the foreseeable future and may become even more prevalent. For example, Germany recently became the first eurozone country to sell 10-year debt at a negative yield. The ultimate result, Hoag predicts, will be heightened market volatility.

But that “does not mean investors should have a bunker mentality and put everything in cash,” Hoag  says. “It means that investors should have a balanced portfolio of investments that can appreciate and provide income over time.”