Why ultra-low/negative interest rates don’t work…
Crux note: The following essay is an excerpt from an essay entitled Negative Interest Rates – Won’t You Take Me To Funkytown? by the staff over at ValueWalk. We think it may be one of the simplest explanations of why central bankers around the globe have failed to stimulate their economies with ultra-low or negative interest rates…
On Friday the Bank of Japan (aka, the Japanese Fed) cut the rate on current accounts that commercial banks hold with it to minus 0.1%, adding that it will push the rate even lower if needed.
Effectively, this means that banks will be charged to keep excess assets with the central bank. This move sparked a big jump in stock markets around the world.
Some mistook the rise as being predicated on the assumption that negative interest rates would work to spur growth and therefore earnings and therefore stocks. This is wrong.
Stocks moved because as a financial asset they became slightly more attractive than they were the day before, especially when having cash has a tangible cost, and when the same people that just took rates negative said they will take them more negative if they have to. So asset allocators did the logical thing and decided that the prospect of losing money in stocks was more attractive than the guarantee of losing it in bonds.
So stocks went up.
The common explanation for negative interest rates in countries that have implemented them is that negative rates will encourage banks to lend and consumers to spend rather than save. It’s the same argument for keeping rates low all over the world – low rates drive lending which drives consumption by individuals. But this isn’t happening. Japan has had ultra-low rates for years and its economy has been terrible. Trillions of debt in Europe now trades at negative interest rates and its economy isn’t exactly booming.
Denmark, Sweden and Switzerland all have negative interest rates, but consumer spending isn’t going up there. In fact, savings rates have been going up in lockstep with the decrease in interest rates, exactly the opposite of what the geniuses at the various central banks expected.
Why is this happening?
Simply, savers are scared.
Lower interest rates have wrecked their retirement plans. Say you were doing some financial planning 10 years ago and plugged in 3% from your savings account. Now its 0%. You still have to plan for your retirement. Plug in 0%. What happens to your planning now? 0% compounded for X years is 0%. The math is simple. So in order to have your target savings at retirement, you need to save more, not spend more.
But for some reason, the economists that run central banks around the world can’t see this. They are all stuck in their offices talking to one another and self-reinforcing this myth that they can drive spending up by reducing the rate of return on investments. Want to see consumer spending go up? Don’t wreck their savings plans so that they are too scared to spend. But that’s too simple. Instead, central banks use a chain of causation that doesn’t exist to try to create change 3 or 4 steps down the line. It hasn’t worked, and it won’t work. It isn’t in an individual’s self-interest to go out and spend their money on more “stuff” in order to spur economic growth.
So how do you get people to do collectively what isn’t in their own best interest to do individually? Put another way, how to you get people to spend the savings they think they will need in the future to ensure some basic level of survival, and instead spend it today?
I think governments need to be very explicit in what they are doing. Right now, they use terms that the average person doesn’t really understand, or, put differently, people don’t understand how the policies being tried over and over are supposed to affect them. So they ignore them.
Why do central banks want higher inflation (of about 2%)? Because they think that this is the optimal level that will make people spend today instead of waiting for something to be cheaper tomorrow. At 0% inflation, there is no incentive to spend today versus a year from today, as prices will be the same. The Fed targets 2% because it believes that is the “right” level that will make consumers move to spend sooner.
They are wrong.
Consumers don’t think that way. They think in terms of what do I need, what do I want, and what am I willing to pay for it. Needs are bought somewhat irregardless of price. Think food, and homes. Most people in the U.S. actually like it when home prices appreciate at a level that they can see – like 4-6%. I’d hazard to guess that this is the level of interest that would make them feel comfortable spending a bit of their savings too. The Fed is literally “too cute” by half. No one cares about 2%. It’s meaningless. People don’t shop their credit cards, or even call the issuer of the ones they have, for 2%. It’s seen as not worth their time. So all this talk about quarter point moves, half point moves, negative interest rates, is just that – talk.
The people the message is intended for aren’t listening.
So again, how do you get people to do collectively (spend now) what isn’t in their best interest to do as individuals (if the prices of goods are going down or are flat, then saving and waiting for the better quality TV, or car, or clothes, makes perfect sense)? Insuring against disaster – like losing your home altogether – carries a lot more weight in people’s minds then losing 2% in purchasing power through some unseen inflation that doesn’t even exist at the moment anyway. Central bankers are so divorced from reality that they really think (or at least act like they think this way) that these small moves in borrowing rates, even to negative interest rates, will scare people enough about their future purchasing power that they will throw caution to the wind and go buy stuff they don’t really need now. Because if the really needed it, I mean, need it to survive, they probably already bought it, don’t you think?