Negative Interest Rates and the Mattress

Interest rates have a strong influence on consumers investing, homes and cars affordability, college loan payments, and the income retirees receive from their retirement plans.  Currently, interest rates are low – conventional 30-year mortgage rates have dropped to 3.64% and a 10-year Treasury bill yields 1.6%.  Depending on whether consumers are the borrower or lender, those interest rate levels are good or bad, but we may soon face negative rates and strange behaviors they encourage.

Negative interest rates look like this.  A consumer deposits $100 in a bank account and leaves it intact until the end of a year.  At that time the account balance is less than $100.  If you were “investing” in Treasury bills in a negative interest rate environment, at maturity you would have received less than you paid for the bill.  It will seem like the financial institutions are offering no interest and charging you for safekeeping your money.

Central banks in Japan, the Euro area, Denmark, Switzerland, and Sweden have imposed negative interest rates (-0.1% in Japan and -0.3% in Euro area) on deposits made by some of their banks.  That should discourage banks from stashing cash at the central bank.  Instead it encourages them to make more commercial and personal loans.  Those loans should stimulate economic activity.

Of course, when the borrowers spend the cash, much of it ends up back in the banks as deposits from other people.  When banks start charging negative rates to consumers, many will convert modest deposits into cash and store their money under a mattress.  That doesn’t work for business cash piles.

When asked about negative rates at a Congressional hearing, Federal Reserve Chair Janet Yellen said “We wouldn’t take those off the table.”  While that is unwelcome, US banks may be forcing her hand.  At current low interest rates, US banks have $2.27 trillion in reserves at the Fed, compared to the required $117.3 billion. Evidently US banks are not seeing demand for worthy investment loans.  But, if the cost of parking money at the Fed becomes painful, perhaps they might lower their profit expectations on commercial loans.  Unfortunately, refinancing home mortgages cannot help because in refinancing, payoffs restore payouts – it’s nearly a zero sum game.

NOTE: This is not investment advice.  Negative interest rates could be a disappointing development for those dependent on retirement accounts.  The specific mix in each retiree’s account would determine the outcome, but a drop in interest rates will increase the market value of bonds and CDs already in the account. Of course, the interest rate decrease will not improve the account’s interest income, and any new bonds would promise a lower yield than offered today.  The fixed income side of the retiree’s account will produce the same or less income than it does today.

If the negative rate squeeze-play on banks results in additional commercial investments, it could leaven the stock market in the short run, but when the Fed eventually “normalizes” at interest rates near 4%, the stocks may swoon.  A bout of negative rates will provoke some bizarre behaviors, but the overall flavor will be unpleasant.