How Negative Interest Rates can Affect Consumers

How Negative Interest Rates can Affect Consumers

In April 2016, BlackRock Inc. CEO Larry Fink cried out against the global trend toward negative interest rates and argued that such policies were doomed to backfire. Fink pointed out that nonexistent interest rates make it impossible to generate a return on savings, thereby forcing workers to save larger proportions of their income. This is precisely the opposite of what negative interest rate policies (NIRPs), such as those implemented in Japan, Sweden and the rest of the European Union (EU), hope to accomplish. Regardless of whether Fink is correct, he raises an interesting question about the impact of negative rates on investors and consumers.

A negative rate regime is designed to encourage huge banks to lend or invest their excess reserve deposits, and to reduce the interest burden on national governments. As strange as it sounds, consumers do not usually enter the equation because they do not directly interact with discount rates or huge government bond purchases. Classic economic analysis only suggests that low interest rates should discourage savings and encourage borrowing, investing and spending.

What Economic Theory Says

For years, negative interest rates were supposed to be an economic oxymoron. Logically, a loan contract could only reasonably apply real negative interest payments if the lender preferred less future consumption to more present consumption. For example, you would only buy a $1,000 bond with a negative real yield if you valued holding $1,000 today less than, say, $950 at some point in the future, even after adjusting for potential deflation. Very few, if any, people would accept such a contract.

NIRPs only deal in nominal interest rates, so negative rate loan contracts might make more sense in an economy with deflationary expectations. Of course, low-rate contracts are great for borrowers, at least superficially, because they reduce interest payments. Negative rates also depress interest on deposit accounts, such as savings accounts or certificates of deposit (CDs). Some macroeconomists hope low interest rates will encourage borrowing and drive money out of savings accounts and into higher-risk investments, such as stocks or mutual funds.

Keynesian macroeconomic theory says NIRP might be necessary if there is an output gap or when actual GDP is below potential GDP. New spending and investment should promote business expansion and hiring. Keynesians only consider NIRP when a zero interest rate policy (ZIRP) proves ineffective.

Austrian economists worry that NIRP or ZIRP encourages unwanted inflation and allows businesses to undertake riskier projects because financing is cheaper. When future consumer savings prove insufficient to pay for such projects, a necessary correction could lead to another recession.

A Deterrent for Investors

If negative rates drive money out of savings and into other assets, the price of those other assets may become overvalued. This may explain why housing prices and stock prices keep rising in the United States despite flat or declining profitability, dividends and rents.

As asset prices rise, potential real returns from those assets decline. This makes investments less enticing to investors, and may deter investors who are concerned about a bubble or correction.

Hard on Low-Income Consumers

Negative interest rates drive more currency into circulation by encouraging more loans. All else equal, higher volumes of circulated currency force prices higher than they otherwise would have been. This means it costs you more to buy gas, food, housing, clothing and other goods and services.

This is suboptimal for all consumers, but it tends to hit low-income and fixed-income consumers the hardest. Those living on government assistance, pensions or low-wage jobs are less likely to see a corresponding boost in real income.

Banks Pass Costs to Consumers

Negative rates put a squeeze on bank profits. If a bank has to either accept riskier loans or pay fees to store deposits at the central bank, it may decide to compensate by passing costs along to its depositors. One way to do this is to charge a storage and security fee on demand deposit accounts, but other measures such as higher ATM fees could be more likely.

Cheaper Auto and Home Financing

Absent other factors, NIRP should encourage car loans and home mortgages. After all, cheaper interest payments mean you might be able to afford a nicer car or bigger home. Unfortunately, most Americans are already net debtors and need to pay down their existing loans, not take out more.

Added Uncertainty Increases Demand for Liquidity

Thus far, low-interest rate policies have been ineffective at promoting economic growth. Businesses are more leveraged in 2016 than at any point since the Great Recession, and real incomes are not keeping pace with the cost of living. There is widespread concern in financial markets about a possible global recession in late 2016 or 2017. Consumers may find themselves saving more money and avoiding equities as a cautionary practice.