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A central bank is responsible for setting a nation’s monetary policy. To encourage lending and spending, the US Federal Reserve (Fed) has set interest rates at nearly zero to make borrowing inexpensive. But to support the economy even more through the COVID-19 pandemic, there’s debate about whether the Fed should introduce a controversial policy—negative interest rates—to incentivize spending that much more.

number one

It’s all about reaching goals: A central bank’s ultimate goals are to keep the country’s currency and economy stable and to maintain a healthy employment rate. By raising or lowering interest rates, central banks such as the Fed can impact those goals by influencing a country’s money supply. 

number two

A tool that works two ways: If the Fed is concerned that rapid economic growth will lead to high inflation, it can raise interest rates—make it more expensive to borrow money—in an effort to slow spending. If the economy needs support, lowering rates can help encourage spending and business investment. For example, the Fed reduced rates to near zero after the Global Financial Crisis, started raising them in 2015 as the economy’s recovery took hold, then lowered them again during the COVID-19 pandemic when the economy shut down.

number three Desperate measures: In extreme circumstances, central banks can even push interest rates below zero. While they’ve never been used in the US, the European Central Bank and the Bank of Japan have had negative interest rates for several years as part of their recovery from the Global Financial Crisis. 
number four


Isn’t it automatically bad when something is negative? In theory, negative rates are meant to keep money flowing in the economy by making it more beneficial to spend money than to save it. Another way of looking at it is a little pain now in exchange for a potential long-term gain in the form of an economy that keeps growing.

number five

So wait, negative rates can actually be a good thing? Negative rates could be beneficial for businesses and some consumers since it drives the interest rates on mortgages and loans to rock bottom—or even pays them to borrow money. Essentially, negative rates make for a good time to invest in big purchases that need to be financed.

number six

But not everyone benefits: Banks may choose to eat the cost of negative rates rather than pass it on to consumers as a fee for depositing money with them. But even so, interest rates would be so low that savers could actually lose money by keeping it in the bank, especially after factoring in inflation. Bondholders may also lose out—a bond with a negative yield wouldn’t pay back enough interest to cover the original purchase price.

number seven

However, bonds would still be an important investment: Even if rates in the US were negative, US government debt is still considered a high-quality, “safe haven” investment. Low or negative rates don’t negate creditworthiness.

number eight

Negative rates abroad could actually pay for US investors: There’s currently more than $13 trillion of negative-yielding debt in global markets.1 But professional money managers may have the skill and experience to turn that negative into a positive by applying currency hedging to potentially generate positive returns for US bond investors (see FIGURE 1 below).

number nine

You won’t find negative rates in your macroeconomic textbook: There’s debate as to the effectiveness of negative rates. It’s a very modern strategy—in 2014 the European Central Bank was the first to cut short-term rates below zero. With such a limited history, it’s difficult to determine whether or not it’s been effective, making it a somewhat controversial tactic.

number ten

Unlikely to happen here, but worth understanding what the fuss is about: The Fed has consistently opposed pushing rates below zero. In light of Europe and Japan’s experience, the concern is that the risks outweigh the reward in the US: Both banks and consumers could be too negatively impacted to reap the potential long-term benefits.

FIGURE 1

Five-Year Government-Debt Yields Tend to Improve When Hedged to US Dollars

Past performance does not guarantee future results. Sources: Bloomberg and Wellington. Data as of 3/31/2020.

Talk to your financial professional about how changing interest rates can impact your individual situation.

 

1 Source: Bloomberg Barclays Global Aggregate Negative Yielding Debt Index as of 3/31/21

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments.

This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice.

CCWP089 223598

 

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