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Negative Interest Rates Will End in Disaster

This is Your Signal to Buy Gold

Written by Geoffrey Pike
Posted June 13, 2014

I recently wrote about the possibility of the European Central Bank (ECB) imposing a negative interest rate.

Sure enough, on June 5, Mario Draghi and the ECB announced there would be a -0.1% rate on bank reserves.

In other words, banks would actually have to pay a small interest rate on money they keep on reserve with the central bank.

I often say we live in unprecedented economic times; you can add this to the list. This is the first time a negative interest rate has been imposed by a major central bank.

The ECB members are worried about a lack of price inflation, sometimes referred to as disinflation. They are afraid of a deflationary situation where prices are going down because, in their Keynesian minds, this will be bad for the economy.

They believe deflation is bad for the economy because when people expect lower prices, they will continually hold off on buying, which just perpetuates the cycle.

This theory is obvious in the electronics industry, where televisions and computers continually get cheaper. I am personally holding off for the iPhone 20S, when it will only cost $10. (Please note the sarcasm of this paragraph.)

Central banks are supposedly scared of price deflation, but let’s ask what the reasons for deflation would be. There are only a few reasons an overall decrease in prices would happen...

First, prices can go down due to increasing technology and productivity.

As mentioned above, electronics get cheaper and cheaper, while the quality and power generally go up. This is a simple result of increasing technology and productivity. We are better off for it.

I would rather pay $500 for a computer that is twice as fast as a computer from two years ago that cost $1,000. Most people can understand that this is a benefit and actually increases our standard of living.

A second reason prices go down is due to changes in the money supply.

To be clear, there doesn’t necessarily have to be a decrease in the money supply for us to experience some kind of price deflation. It could be a bust from a previous artificial boom that took place due to a massive increase in the money supply. Regardless, this would be due to central bank policy, which controls the money supply.

I should also add that an increase in the demand for money can also lead to falling prices. But again, this would typically be the result of changing monetary policy.

So any price deflation that may be experienced is either due to greater technology and production — which is a benefit — or else it is due to an attempted correction by the marketplace to readjust the misallocated resources that were caused by prior tampering with the money supply.

Will the ECB Create More Price Inflation?

A negative 0.1% interest rate is extremely small. A bank could still hold reserves at this rate for many years before it lost even 1% on its holdings.

With that said, all prices are marginal in the sense that changes are made at the margin. The negative interest rate, even though it is low, may be enough to cause some banks to lend out money that otherwise wouldn’t have.

On the other hand, if there is a sense of fear and uncertainty, along with a lack of worthy borrowers, most banks may just take the small penalty and avoid the risk. We will have to wait and see for sure how the banks in Europe react to this new policy and if it makes any substantial difference.

Ironically, the ECB’s policy may just make the banks that much more unstable. They will either have to make risky loans to avoid paying the penalty (the negative interest rate), or they will have to slowly pay out money just to keep deposit money “safe and sound.”

This is ironic because one of the major problems since the fall of 2008 has been the solvency of the banking system. In this sense, the Fed has probably handled the situation a little bit better — at least from the point of view of bank solvency.

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Will the Fed Follow Suit?

A big question that looms is whether the Federal Reserve will follow in the footsteps of the ECB and impose a negative interest rate. At this time, I believe the Fed will not.

Why would the Fed do something to disrupt its current delicate policy that is momentarily “working?” After all, the economy hasn’t dropped off a cliff (yet), and we have not seen massive price inflation (yet).

The Fed has quintupled the adjusted monetary base since 2008, yet we don’t have massive price inflation due to the lack of lending. In doing this, the Fed has also been able to secretly bail out the banks by buying mortgage-backed securities at below market value.

The Fed has been paying 0.25% on bank reserves since late 2008. This also sets a ground floor for the federal funds rate, or the overnight borrowing rate, that everyone obsesses about.

Most banks don’t have to borrow overnight funds due to the massive excess reserves that have been built up. They also don’t need to lend money for overnight borrowing because they are collecting 0.25% from the Fed.

Why would the Fed go to a negative interest rate when it is currently paying banks to keep reserves? If anything, the Fed would first decide to stop paying banks an interest rate. I have no idea if this would make much of a difference in lending, as banks are still rightfully scared to lend out money to just anyone.

If banks do start lending out their excess reserves, then the money will multiply through the economy through the fractional reserve lending process. This would likely lead to extremely high price inflation, which the Fed does not want because it would take away its ability to play around with the economy and to fund Congress’ massive deficits.

At this point in time, I see no reason for the Fed to change its policies from its point of view. It is content with an economy chugging along, even at a slow pace, along with perceived low price inflation.

Things Could Change

The Fed is always attempting a balancing act between inflation and a struggling economy. The Keynesians believe it is sometimes a choice between one or the other. They think if the economy is doing poorly, then inflation must be increased to help the economy — even though this whole idea was proven wrong in the 1970s.

While we may eventually see a depressed economy and high price inflation, I think it is a question of which one becomes more of a problem first for the Fed.

If the economy is looking really bad and price inflation is still relatively low, then the Fed could eventually do something similar to the ECB and impose negative interest rates. We just aren’t there yet.

When the Fed starts to become desperate in trying to raise prices, that will be our signal to become desperate in getting out of U.S. dollars — our signal to move more heavily into hard assets such as real estate and gold and to avoid dollar-denominated assets such as U.S. bonds.

We really do live in unprecedented times, and the ECB is providing us with another Keynesian experiment that can only end in disaster.

Until next time,

Geoffrey Pike for Wealth Daily

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