2016 3rd Quarter Commentary
HOW IN THE WORLD DID WE GET THESE NEGATIVE INTEREST RATES?
One of the most common questions we have had over the last few years has been about negative interest rates and why they are bing imposed by central banks. As recently as June of this year, the Swedish National Bank, Swiss National Bank, Denmark National Bank, European Central Bank, and the Bank of Japan all had negative interest rates.
Historically, when the economy is in a recession, the central banks of different countries lower interest rates to encourage consumer borrowing to purchase goods and services. In the past, the lowering of interest rates has, indeed, stimulated the economy by creating more purchasing activity. The idea has been to lower the interest rates until there is a pick-up in the economy. Then, as the economy heats up, bring the interest rates back up to a reasonable level. That reasonable level in the United States has been around 4-5% over the last 45 years.
Since the 2008 recession, the Federal Reserve Bank lowering the interest rates has not moved the needle on economic activity. That has been the case all around the world. Taking the interest rates negative adds another level of pressure to make loans. In each country, or zone, the central bank is the repository for all of the commercial banks under its jurisdiction. That means the local commercial bank keeps its cash reserves on deposit at the central bank and earns interest there. The central banks that decided to go negative on interest rates turned away from creating incentives for banks to make loans and toward creating punishment for banks that failed to lend. In a country where the central bank has negative interest rates, instead of earning interest on the deposits, the lending banks actually have to pay a penalty to the central bank for them to hold their money. The central banks thought negative interest rates would cause the local banks to increase their lending so they wouldn’t have to pay the central banks to hold their money. So far, negative interest rates have not produced the increase in lending that the central banks had expected. Many feel that banks with lower profitability are less likely to make loans, so negative interest rates could actually be causing the exact opposite result of what the central banks intended.
The negative interest rate phenomenon has introduced an increased level of uncertainty in the economy for both borrowers and lenders. Everyone realizes that there are no interest rates to cut should we go into another recession. Most of us in the financial industry never dreamed we would see negative interest rates in our lifetimes. It is an experiment the central banks are trying. So far, it doesn’t seem to have worked.
We believe if there were a gradual and measured series of interest rate increases from the Fed, it would actually have a positive effect in the long run.
Sources: The Wall Street Journal; “Investment Insights,” Capital Groups; “How Negative Interest Rates Work,” Matthew Johnston; “Negative Interest Rates: 4 Unintended Consequences,” Adam Hayes, CFA.
These are the opinions of Financial Professionals, Inc. and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is not a guarantee of future results.