Why Our Economy Needs Negative Interest Rates

People ask about things like “will the dollar be devalued?” Or “what investments hedge against devaluation”? To answer these questions one should look at the big picture of the economy and see that there is a need for interest rates to be negative in order to stimulate the economy.

With the risk of an unfundable series of sovereign bond defaults in the Eurozone, and a potential for a crash in China, the whole world is at risk of falling into Japan-style deflation.

If rates become negative then foreign investors would sell their dollar holdings to invest in countries with higher interest rates and this would make the dollar go down. But that would also help create more export jobs, thus ending the high jobless rate.

There was a study published recently (sorry I can’t find it) that showed that short term rates need to be negative 1.65% for the economy to be in equilibrium and thus return to a normal level of employment and production.

How can interest rates become negative?

It seems counter-intuitive for interest rates to go below zero. Let’s look at the history of banking to understand why this is possible. In ancient times there were no banks, so people used gold as money and when they wanted to store it they paid a goldsmith to store their gold (a form of money) in his vault. The act of paying a fee to store money is a form of negative interest rates. Leasing rates for gold are often close to zero and when you subtract the cost of storing, shipping, assaying, insuring gold from the lease income then you have a negative number.

U.S. TIPs have short term negative real interest rates. (Although Treasuries are not money, they can be instantly converted to money, subject to a three day settlement). Bu negative rates I am referring to nominal rates.

If the marketplace believes that nothing is safe then the market would be in the same position as ancient times when people had no choice but to pay a fee to someone to store their gold (money) instead of getting interest on a bank deposit.

So the concept of negative interest rates should not bother anyone. It should simply be a practical question of how does the Fed create negative interest rates.

The Fed could buy any Treasury with a maturity of less than three years at a premium price. For example, a two year T-Note could be bought by the Fed at 104, a 4% premium, thus creating a market price that implies the buyer would lose 2% a year from amortization of principal, less the note rate of 40BP = 1.6% annualized negative rate of return.

The FDIC might need to impose a used fee on short term bank deposits (under two years) of 2% per year to be paid by depositors.

About the author

Don Martin, CFP®

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