Earlier this week, the president again criticized the Federal Reserve. Calling chairman Powell and his colleagues “boneheads,” the president expressed frustration that they haven’t done more to lower interest rates. Specifically, the president said, we should, “get our interest rates down to ZERO, or less.” That last part—“or less”—was key. Not only should rates be lower, he argued, but they should be below zero, as they have been in Europe.
So far, the Fed has resisted this pressure and is holding its target interest rate well above zero. And I hope they continue to do so. While I understand the president’s perspective—as a borrower, the Federal government would benefit from lower rates—I see at least ten ways that negative rates would hurt our economy, and investors, over the long term.
1. Low rates punish retirees. Consider what life looks like today for a retiree in Europe. In Germany, 10-year government bonds are now paying negative 0.52%. Translation: Instead of earning interest when you buy a bond, you would instead have to pay the government to take your money. It’s completely upside down.
2. Excessively low rates cause investors to “reach” for yield. With rates on high-quality government and corporate bonds providing paltry income, many people throw caution aside and purchase lower-quality bonds. Why? Because that’s the only way to earn a higher rate. But this is a dangerous move. Low-rated bonds carry low ratings for a reason: They’re riskier. If rates went negative, the result would be even more investors facing this uncomfortable choice.
3. In our country, savings rates are already too low. And yet, negative interest rates would further disincentivize saving. In fact, negative rates would effectively become a wealth tax. Think about it this way: If the government sells you a bond for $1,000 but pays you back just $995, that is a mechanism for taxing people’s savings. This is a well understood concept among economists. First proposed in the 1860s by German economist Silvio Gesell, negative interest rates are a mechanism to discourage saving and encourage spending. That might be a good idea during a recession, but it’s not what we need today.
4. The U.S. government’s indebtedness is near historic highs. Negative rates would allow the government to become even more indebted. While there are some who argue that government debt doesn’t matter, I find that notion illogical. Even if rates are slightly negative, eventually the government would need to pay bondholders back. In other words, it’s not the interest rate that’s the problem; it’s the principal. As a U.S. taxpayer, this should concern you since there are only two ways to get ourselves out of debt: higher inflation or higher taxes. Neither would be good for investors.
5. Ultra-low rates enable highly-indebted companies to continue borrowing. According to a Bank of America analysis, low rates have created a large and growing class of “zombie” companies that are living on borrowed money. Eventually, if rates rise, some number of these zombies will sink into bankruptcy, taking their employees and creditors with them. Negative rates would fuel this trend, making the eventual crash even worse.
6. Low rates also incentivize consumers to take on more debt. After the 2008-09 recession, consumer indebtedness declined. In recent years, however, it has climbed back up. And unfortunately, consumers aren’t keeping up. Delinquencies are rising, putting a growing number of people in a precarious position. What is fueling this debt binge? Low rates. And if rates go lower, it will only get worse.
7. Low rates artificially inflate the stock market. There is an inverse relationship between interest rates and stock prices. The lower rates go, the higher stocks go, and vice versa. This is true for a variety of reasons, the easiest of which to understand is corporate debt. Take a company like Apple, which carries more than $100 billion in debt. If rates were to drop by 1%, that would lower Apple’s financing costs by $1 billion a year. And all else being equal, that $1 billion in savings would flow through to its stock price. While this is great in the short term, rates will inevitably have to rise, and when they do, it will take the air out of stock prices. (In fact, if you recall the stock market tumble in the last quarter of last year, the proximate cause was rising rates.)
8. Inflation. Just as low rates artificially prop up the stock market, they can also drive up inflation, for a similar reason. When rates are lower, everyone has more disposable income. That includes companies and consumers. The result: Companies hire more people at higher wages, and consumers spend more. These are precisely the ingredients for higher prices. In recent years, inflation has been benign, but anyone who lived through the 1970s can tell you what a corrosive effect it has at higher levels.
9. The Fed’s ability to lower interest rates is a key tool for lifting the economy out of recession. When the economy sours, the Fed lowers rates, putting money in people’s pockets to get things moving again. But if rates are already low while the economy is strong—which it is—that will deprive the Fed of this ability when it weakens. In colloquial terms, they’ll be all out of bullets. That’s not a good thing.
10. Low rates hurt banks. If you have money in a savings account, you know how banks make money. They pay you nearly zero to hold your savings, then they lend it out at much higher rates to other people. What happens when interest rates come down? Banks have to lower their lending rates to stay competitive. But when deposit rates are already near zero, they can’t go any lower. The result: Banks can’t earn as much of a profit on the “spread” between those two rates. While you may not have much sympathy for banks, it is nonetheless important for everyone that our banks remain strong. Look no further than 2008 to find out who picks up the tab when banks fail.
