Janet Yellen raised eyebrows earlier this month when she hinted at the possibility of negative interest rates in the U.S. “We wouldn’t take those off the table” were her exact words. Since then, I’ve gotten a few questions about whether negative rates could be a useful tool in stimulating the economy or whether this is a sign of central banks grasping desperately for that objective.

Truth is, there really isn’t enough historical evidence to outright support or refute negative rates. Here at Zacks Investment Management, we can’t really ascertain the probability of success. Since it’s a new central bank policy mechanism, it’s very much a wait-and-see experiment. But, on pure economics, I’d call the idea of negative interest rates, well, negative.

The Theory and Goal behind Negative Interest Rates

First, a quick explanation of why central bankers think this might work. Through profitable operations over time, large banks build up cash reserves. A central bank, like the Federal Reserve, gives banks a place to ‘park’ some of those reserves for safe keeping and build up reserves to hedge against downturns. A central bank, in turn, uses interest rates (or laws, like Dodd Frank) to encourage or deter banks from keeping excess reserves at the central bank.

Central banks hope that, if they pay low levels of interest on reserves, banks will instead choose to loan that money out at a more attractive rate. If a central bank is paying 2% on reserves, but a bank can initiate a 30-year mortgage at 5%, the bank would probably rather make the loan – net interest margins are much higher. If conditions are such that banks would rather lend, and take risk instead of just letting reserves ‘sit there,’ then the economy benefits via more lending activity and favorable credit conditions – and growth usually follows.

When central banks initiate negative interest rates, however, not only are they dis-incentivizing banks from keeping excess reserves parked there, they are also making them pay to keep reserves parked. Central banks are trying to force the hands of banks to lend, and that’s not good policy in my view. The ideal economic circumstance is when banks choose to lend because the yield curve is upward sloping, net interest margins are attractive and the economy is strong enough to support risk taking. You could argue that all three of those factors are in a middling phase that negative rates won’t fix.

Europe and Japan are trying the approach anyway and, again, this “tool” hasn’t been around long enough to know whether it might stoke lending. One bright spot is that the European Central Bank protects banks from suffering losses (through negative rates) on the reserves it legally requires them to have, which is about 15% of the total. Sweden actually makes banks pay interest on reserves it makes them keep at the central bank by law! An insensible policy.

Bottom Line for Investors

The overarching reality is that negative rates in the U.S. probably won’t happen anytime in the next few years and, by then, we’ll know whether or not it produced the intended results in those countries that have gone that route.

It’s a bit of a crapshoot for banks. On one hand, in the aftermath of the financial crisis, central banks are requiring a build-up of reserves to weather the next potential downturn. On the other hand, they want banks to lend more so that economic growth gets support. It’s a mixed message and markets don’t like mixed messages. They like to be left alone.

Lending activity in the U.S. is healthy and growing, a sign that banks are generally comfortable with the economic environment. Negative interest rates would probably only serve to make banks feel pressured, and that’s not good. Better, in my view, to avoid that outcome.

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