The negative interest rate nightmare may become a reality

The Bank of Japan recently shocked the financial world by adopting negative interest rates – a radical move that's supposed to stimulate their perpetually sluggish economy.  The theory is that negative rates will stimulate lending, encouraging banks to make riskier loans and for depositors to increase the velocity of money by circulating it faster.

But in practice, well, nobody knows.  Negative interest rates is an untried practice, and the risk of backlash against banks is one of the major unknowns.

The European Central Bank is now fiddling with negative rates as another credit meltdown looms.  Might the Federal Reserve be next?  Chairman Yellen says no, but at the same time, she is telling banks to prepare for them.

For the first time ever, the governing agency and U.S. central bank is requiring banks to include, in a round of stress tests commencing this year, to prepare for the possibility of negatively yielding Treasury rates. The scenario is purely hypothetical and not a forecast, according to a Jan. 28 Fed news release .

However, the development is part of a larger scenario of a world where zero rates are morphing into negative rates.

This is how beggar-thy-neighbor monetary policies work, and perhaps why they ultimately fail.

One nation mired in an economic slump decides that the best way out is to devalue its currency, cheapening its exports and thus making them more attractive in countries that have higher-yielding currencies and, consequently, more buying power.

Seeing the success that country has, another seeks to emulate. And then another. And another. And another. In order to stay ahead of the game, central banks keep devaluing until there's nothing left, tangibly at least, to devalue, and negative interest rates come into play.

The Bank of Japan has softened the blow of negative rates by making it possible for its banks to avoid giving depositors a "haircut."  But in practice, depositors will have to think twice about keeping any money in the bank if institutions charge customers for the privilege.

An editorial in The Economist explains:

Small savers would use any available form of prepayment—gift vouchers, long-term subscriptions, urban-transport cards or mobile-phone SIM cards—to avoid the cost of having money in the bank.

That would be only the start of the topsy-turviness. Were interest rates negative enough for long enough, specialist security firms would emerge that would build vaults to store cash on behalf of big depositors and clear transfers between their customers’ accounts. Firms would seek to make payments quickly and receive them slowly. Tax offices would discourage prompt settlement or overpayment of accounts: one Swiss canton has already stopped discounts for early tax payment and said it wants to receive money as late as possible.

If you think that sounds scary, you're absolutely right.  It would change the way most of us live.  Why allow for automatic transfer payments to utilities and credit cards if keeping cash in the bank becomes an expensive proposition?  We're not talking about a "fee" to maintain a checking account.  If you keep $10,000 in savings and checking accounts in the bank, you're looking at several hundred dollars a year in costs.

In effect, the U.S. economy would once again become a cash and carry economy:

Concerning the flight to cash, that could be dealt with as well. To remind, with negative rates in place, cash is a better place for savings than a bank account. The possibility that people might switch to cash therefore makes it difficult to force rates below zero. The cost of holding cash (including the risk that it might be stolen) creates some room for maneuver. Beyond this, central banks could further discourage the use of cash by forcing down its value relative to electronic balances -- in effect, taxing its use -- or move to abolish it altogether.

Undermining paper currency in this way would be politically fraught, at best. Yes, inflation undermines paper currency, so the phenomenon is hardly new. But no central bank will want to say, "We can't get inflation any higher with our usual methods so we've decided to undermine the currency directly."

Suppose they did dare, thinking they could get away with it and reckoning that the economics is correct even if the politics is, you know, challenging. With financial anxiety running high and the flow of credit blocked, would such a dramatic departure actually work as intended, helping to calm nerves and incline borrowers and lenders to take risks? It might very well do the opposite. A reckless-seeming experiment is not the best way to restore confidence.

Some analysts believe we're talking ourselves into a recession with all the doom-and-gloom prognostications from the financial press and some institutional investors.  But the evidence is right in front of us.  Banks are sinking, profits are shrinking, and the flight to gold and other safe havens is well underway. 

Are negative interest rates on the way here?  Yellen may not want them, but in the end, she may not have a choice.

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