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Will negative interest rates prompt a recovery?

The US Federal Reserve

In an attempt to encourage a global economic growth, governments around the world have taken dramatic efforts to increase the money supply. The problem is, the money isn’t flowing as planned.In the US, the Federal Reserve through a campaign of ‘quantitative easing’ is buying back Treasury Notes in ‘open market’ activities. The intent is to load the financial institutions with cash to lend to companies and individuals.The problem is, the funds aren’t going anywhere. What will prompt the money to start flowing? Will the Fed to charge the financial institutions a storage fee for holding on to too much cash?“The Federal Reserve does not print money, they make (bank) reserves, to be spent by banks,” noted renowned prognosticator and author Gary Shilling who holds a PhD Economics from Stanford University.He addressed nearly 200 people at the tength anniversary dinner for the CFA Society of Bermuda. He went on to explain that banks are holding on to their ‘cash’ reserves in large part because the companies and individuals with the best credit ratings are not borrowing. They themselves are ‘awash with cash’ having been on a ‘savings binge’ after the 2008 meltdown.So what is a Federal Reserve Chairman to do, to fulfil the dual obligation of manage inflation and encourage full employment?Charge the banks storage for holding the reserves. Take gold, for example. It used to be the reserve of choice prior to moving to the paper standard. Gold is an asset with a zero interest rate.Holders of gold forgo the interest rate they could receive from Treasuries or from corporate bonds. Yet since it is a tangible asset, there is a cost for storing it. With the book-entry reserves created by the quantitative easing, the banks were compensated for holding excess reserves by the ‘reserve’ rate set by the US Federal Reserve Board.Dr Shilling challenged the audience at the CFA tenth anniversary dinner, “Do you know the last time the ‘reserve’ rate was changed?” No one risked a reply.According to the Federal Reserve Board website, the rate was adjusted in October 2008. “Under the new formula, the rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period less 35 basis points …( it is) intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions …(it is) an additional tool for the conduct of monetary policy.”Amidst the crisis in July 2009, the Swedish central bank took the unorthodox move and cut a key lending rate to -0.25%. Basically, by charging a quarter-percent it prompted depositors to move their money from the banks. This is a rare case when ‘nominal’ interest rates were negative. There are recent situations when the ‘real’ interest rates were negative. A ‘real’ interest rate is the ‘nominal’ or named government interest rate less the inflation rate.A negative ‘real’ rate occurs when inflation is greater than the nominal rate. The nominal rate is used in relation to government bonds. Corporate bonds have an added premium for credit risk in addition to the nominal rate.Governments around the world slashed key lending rates to reduce borrowing costs for individuals and corporations. During this time inflation was contained, so real rates hovered around zero.Dr. Shilling noted ‘that US Federal Reserve would like a real rate less of less than zero’, hence a negative real rate. This is difficult in a non-inflationary environment.As noted in the example above, negative rates should prompt the movement of cash and increase the important metrics of the ‘money multiplier’ and the ‘velocity’ of money. This is basically how the economy changes the money into things worth more thus creating a multiplier effect and how fast the money changes hands. Dr. Shilling presented a graph demonstrating that these indicators were one-third their norm.However, a negative interest rate can suggest DEflation in the near future. If people expect prices of goods or services to decline in the near future, they are unlikely to spend now. This would prevent the intent of increasing spending now. Consumers, as some people preferred to be called, have stopped spending because of the economic shocks encountered over the last few years.This has resulted in deflationary effects due to the lack of demand, which brought prices down. Many consumers became savers and investors by buying up government securities or Treasuries in an effort to protect what was left. Here the negative interest rates were created by paying more for Treasuries than would be received in interest and principle once matured.The zero nominal rates and negative real rates can also be a result of what economists call ‘a liquidity trap’. It is a self-fulfilling cycle wherein expected rewards from investing in assets are low, so investors hold onto cash and the economy stalls.When it stalls, the returns on the possible investments stutter lower. The escape from the liquidity trap when real rates are negative is a challenge. With a rising currency, modest yet rising inflation expectations, and prospects for prompt economic growth, the cycle might be broken.The critical step is to have the excess bank reserves flow into the money supply to change hands and create value for the economy. So far, the US Federal Reserve has not engineered the full response they require to reach ‘escape velocity’.It may be time for the Board to take another look at their monetary tool-box. The challenge is to create a flow of reserve funds without a tsunami from the huge excess that would result in a flood of inflation. We need a steady flow effect, a managed release of reserves followed by a gentle rise in wall of inflation.Patrice Horner holds an MBA in Finance, a FINRA Series 7 License, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any products. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.