Negative Interest Rates Not Solution for Fed
January 26, 2016
Last month, the Federal Reserve raised interest rates for the first time in nearly 10 years. Federal Reserve Bank Chief Executive Officer Janet Yellen indicated that the increase was a result of signs of improvement in the “underlying health” of the American economy. However, economic volatility evident from recent declines in stock and commodity prices suggest that the Fed is unlikely to further increase rates and may even undo its recent rate hike. Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, suggested that the Fed should consider imposing negative interest rates. Kocherlakota suggested dropping interest rates below zero, and some have argued that this would increase employment rates and help the Fed meet its two percent target for the nation’s annual rate of inflation. With sub-zero rates, banks will have to pay the Fed for storing cash holdings. While this idea may sound striking or even impossible, some central banks in Europe have already introduced negative interest rates.
In theory, negative interest rates would make saving money less attractive and encourage additional borrowing and spending, in turn stimulating the economy. However, the Fed should not impose negative interest rates, as pushing interest rates in the sub-zero territory is not a viable solution for economic problems.
If the Fed were to impose sub-zero interest rates, banks would likely pass along the costs to consumers by charging negative interest rates to match. To avoid these fees, consumers might withdraw their funds from banks and store their cash at home instead. Consequently, this would lead to a shortage of loanable funds and eventually push interest rates up instead. While some claim that the difficulties of storing cash outside of a bank make this scenario unlikely, negative interest rates can also adversely affect the economy in other ways. Since banks might try to stop their customers from leaving by absorbing the costs of negative rates, they would struggle to recover from plunging profit margins, effectively undoing the progress made to fix the recent recession.
In the past, several European countries have tried to introduce negative interest rates. However, negative rates have not provided many economic benefits. In mid-2012, the Danish central bank imposed negative interest rates to prevent the Danish krone from losing its peg with the Euro. While the sub-zero rates did help to prevent the national currency from losing its peg with the Euro, it failed to spur economic growth. Meanwhile in Sweden, sub-zero interest rates are leading to an increase in household debt and creating a potential property bubble.
Instead of imposing sub-zero interest rates to improve the economy, the Fed should stick to stimulative measures like the purchase of bonds through quantitative easing. Negative interest rates could mean that savers will be charged a fee for storing their savings in a bank account. Even if banks do not pass along the costs of negative interests to consumers, they will inevitably feel the consequences trickle down like a cold sweat.
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