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Staying Positive

Adam M. Grossman  |  September 22, 2019

PRESIDENT TRUMP recently criticized the Federal Reserve—yet again. Calling Fed Chair Jerome Powell and his colleagues “boneheads,” the president expressed frustration that they haven’t done more to lower interest rates. Specifically, the president said we should, “get our interest rates down to ZERO, or less.” That last part—“or less”—was key. Not only should rates be lower, he argued, but they should be below zero, as they have been in Europe.

Last week, the Fed did indeed cut short-term interest rates—by 0.25 percentage point. Still, so far, the Fed has resisted pressure from the White House and is holding its target interest rate well above zero. I hope they continue to do so. While I understand the president’s perspective—as a borrower, the Federal government would benefit from lower rates—I see at least 10 ways that negative rates would hurt our economy and investors over the long term.

1. Low rates punish retirees. Consider what life looks like today for a retiree in Europe. In Germany, 10-year government bonds are now paying –0.5%. Translation: Instead of earning interest when you buy a bond, you have to pay the government to take your money. It’s completely upside down.

2. Excessively low rates cause investors to reach for yield. With rates on high-quality government and corporate bonds providing paltry income, many people throw caution aside and purchase lower-quality bonds. Why? Because that’s the only way to earn a higher rate. But this is dangerous. Low-rated bonds carry low ratings for a reason: They’re riskier. If U.S. rates went negative, the result would be even more investors facing this uncomfortable choice.

3. In our country, savings rates are already too low. Negative interest rates would further dissuade folks from saving. In fact, negative rates would effectively become a wealth tax. Think about it this way: If the government sells you a bond for $1,000 but pays you back just $995, that is a mechanism for taxing people’s savings. This concept is well understood among economists. First proposed in the 1890s by German economist Silvio Gesell, negative interest rates are a mechanism to discourage saving and encourage spending. That might be a good idea during a recession, but it’s not what we need today.

4. Negative rates would allow the government to become even more indebted. The U.S. government’s indebtedness is already near historic highs. While there are some who argue that government debt doesn’t matter, I find that notion illogical. Even if rates are slightly negative, eventually the government would need to pay bondholders back. In other words, it isn’t the interest rate that’s the problem, it’s the bonds’ principal value—the amount that needs to be repaid when the bonds mature. As a U.S. taxpayer, this should concern you, since there are only two ways to get ourselves out of debt: higher inflation or higher taxes. Neither would be good for investors.

5. Ultra-low rates enable highly indebted companies to continue borrowing. According to a Bank of America analysis, low rates have created a large and growing class of “zombie” companies that are living on borrowed money. Eventually, if rates rise, some of these zombies will sink into bankruptcy, taking their employees and creditors with them. Negative rates would further fuel this trend, making the eventual crash even worse.

6. Low rates incentivize consumers to take on more debt. After the 2008-09 recession, consumer indebtedness declined. In recent years, however, it’s climbed back up. Unfortunately, consumers are now struggling to service this debt. Delinquencies are rising, suggesting a growing number of people are in a precarious financial position. What’s fueling this debt binge? Low rates. If rates go lower, it’ll only get worse.

7. Low rates artificially inflate the stock market. There’s an inverse relationship between interest rates and stock prices. The lower rates go, the higher share prices climb, and vice versa. This happens for a variety of reasons.

For instance, consider what it means for corporate debt—and specifically for Apple, which carries more than $100 billion in debt. If rates were to drop by 1%, that would lower Apple’s financing costs by $1 billion a year. All else being equal, that $1 billion in savings would benefit stockholders. While this is great in the short term, rates will inevitably have to rise and, when they do, it’ll take the air out of share prices. In fact, the proximate cause of 2018’s fourth quarter stock-market tumble was rising rates.

8. Inflation. Just as low rates artificially prop up the stock market, they can also drive up inflation. When rates are lower, companies hire more people at higher wages and those employees then spend more. These are precisely the ingredients for higher prices. In recent years, inflation has been benign. But anyone who lived through the 1970s can tell you what a corrosive effect inflation can have when it’s at higher levels.

9. The Fed’s ability to lower interest rates is a key tool for lifting the economy out of recession. When the economy sours, the Fed lowers rates, putting money in people’s pockets to get things moving again. But if rates are already low while the economy is strong—which it is—that will deprive the Fed of a key tool, should growth later weaken. In colloquial terms, the Fed will be out of bullets. That’s not a good thing.

10. Low rates hurt banks. If you have money in a savings account, you know how banks make money. They pay you nearly zero to hold your savings. Meanwhile, they lend out that money at much higher rates to other people. What happens when interest rates come down? Banks have to lower their lending rates to stay competitive. But when deposit rates are already near zero, they can’t go any lower.

Result: Banks can’t earn as much of a profit on the “spread” between those two rates. While you may not have much sympathy for banks, it’s nonetheless important for everyone that our banks remain strong. Look no further than 2008 to find out who picks up the tab when banks fail.

Adam M. Grossman’s previous articles include Need to KnowPassive Stampede and Adding Value. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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