If interest rates go negative, as some commentators have proposed in the wake of the weak economic recovery, the change could result in unanticipated financial innovations, according to a blog posting by two vice presidents at the New York Fed, Kenneth Garbade and Jamie McAndrews. If the Fed charged interest on excess bank reserves, pushing short-term rates negative, the post envisions drastic changes that could occur in the U.S. banking and payments.
Even if banks start charging savers to keep money in the bank, holding cash isn’t a feasible alternative for most businesses and governments, Garbade and McAndrews say. But smaller businesses and individuals would likely cash out some of their bank balances, requiring the U.S. Treasury to print more currency. Special-purpose banks that immobilize cash in a vault would likely be established to offer checking accounts.
Certified checks could become a popular means of payment, and banks might see their liabilities shifting to outstanding certified checks from deposits, a development that might make them warier about lending.
Theoretically, the situation should play out as the reverse of what happened when short-term interest rates went through the roof in the 1970s. People will prefer to receive checks as payment rather than electronic transfers, so that they can hold off on depositing the payment in a bank, which charges interest.
Overall, negative rates would lead to “socially unproductive” innovation in the financial sector, according to the authors, and would create new risk for market participants.
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Read about Denmark’s instituting negative rates here.