Why Should We Care About Negative Interest Rates?

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by Peter Schiff, Schiff Gold:

Are negative interest rates in our future?

Jerome Powell says absolutely not. But Jerome Powell also once said balance sheet reduction was on autopilot and that the Federal Reserve wasn’t going to cut interest rates. What the Fed chair says today doesn’t necessarily line up with what the Fed chair does tomorrow.

In fact, the markets are starting to bet on negative rates. They are, after all, the next logical step in the Fed’s trek down the path of extraordinary monetary policy.

There are already trillions of dollars in bonds trading globally with negative rates. This makes no sense in a sane economic world, but we don’t live in a sane economic world. We live in an economic world distorted and manipulated into some kind of weird Alice in Wonderland fantasyland by central bankers.

So, why are we even talking about negative rates? And why should we care? What’s the point of negative rates? How will they impact the economy?

Economists L. Dwayne Barney and Paul Cleveland explain in an article originally published on the Mises Wire and reprinted here for your consideration.

Presently there are trillions of dollars of bonds throughout the world with negative interest rates. This is an unprecedented turn of events and one that has many non-professional investors confused. Savers are understandably puzzled as to how it is possible for bonds to carry negative interest rates. After all, would an intelligent person really lend $1,000 to someone only to be paid back $950 one year from now?

Economists historically have taken it as a given that people prefer current consumption over the promise of an equivalent amount of consumption at some specified date in the distant future. If you ask anyone whether they would like $1,000 today or $1,000 in ten years, or even in a year, the choice is uniformly for the immediate cash. The future is uncertain, and the preference is always for the immediate reward. Indeed, this preference for current over future consumption is why interest rates exist: people need to be compensated for postponing consumption to a future point in time.

How is it, then, that so many of the world’s bonds are presently carrying negative yields?

Who is buying these securities? The answer is that they are being purchased by various central banks using new fiat money created with the express purpose of decreasing their yields. Central banks, having the luxury of legally and effortlessly creating new money, are not much concerned with the matter of whether bond prices are too high to make them a prudent investment. Rather, they purport to be actively managing interest rates for macroeconomic reasons such as to stimulate growth, encourage employment, and ensure that inflation is near its long-term “target.”

Consider how the process works through a simple, albeit fictitious, numerical example. A rational investor would find it folly to pay $1,030 for a bond that promises to pay back $1,000 one year from now. But a money-printing central bank, having no profit or loss concerns, would not hesitate to buy such a security—profit is not an issue when bonds are bought with money that is created out of thin air. If the Federal Reserve chooses to create new money and buy bonds, it can drive prices up as high as it would like. In the case of our numerical example, if the Fed drives the price up to $1,030, it has imposed a –3 percent interest rate on the market. If the central bank wants the rate to go even lower, say to –4 percent, then it is a straightforward matter of creating more money and buying more bonds to drive the price up to $1,040.

Thus far, the Federal Reserve has stopped short of pushing rates into negative territory. Nevertheless, following the financial crisis of 2008, the Fed stepped up its purchasing of US government bonds and drove interest rates close to zero. The Fed continued to hold short-term rates well below what would prevail in an unhindered market and has doubled down on its monetary expansion amid the COVID-19 lockdown. Alternatively, foreign central banks have pushed beyond zero and driven interest rates into negative territory. In fact, there is mounting political pressure in the United States for the Federal Reserve to follow suit. The motivation for this intrusion into financial markets is the widely held belief that ever-decreasing interest rates are necessary to expand real economic activity. In addition, politicians like low interest rates, because the latter make the payments on the large and growing national debt less of an immediate concern.

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