3 Dangers of a Negative Interest Rate Policy

Image source: Flickr user Kurtis Garbutt.

Take everything you think you knew about the Federal Reserve's interest rate policy and throw it out the window, because earlier this month Fed Chair Janet Yellen announced plans to run a stress test on the United States' financial institutions to see how they would cope with a negative interest rate environment.

Why banks are considering negative interest rates Think a negative interest rate policy, or NIRP, could never come to the United States? Don't rule it out, as Yellen has hinted that the financial governing body would consider all options to stimulate U.S. economic growth and provide a semblance of stability. Although, to be crystal clear, the Fed has also implied that it's still quite a ways away from even considering a move to negative interest rates.

That, however, hasn't stopped the third-largest economy in the world, Japan, from shocking the world with a NIRP. At the end of January, the Bank of Japan announced it was moving its benchmark lending rate to minus 0.1% in an effort to stimulate its stagnant economy. The BOJ also left in place its current stimulus measures, which include ETF and government bond purchases.

The idea of a negative rate is that it charges banks interest for parking their money in a central bank, which encourages those banks to lend to more of it out to consumers and businesses, which in turn can boost consumption, business expansion, and job creation. As long as benchmark rates remain low, or negative, businesses should, in theory, have more incentive to borrow at a low cost and put their capital to work.

In Japan's case, its economy has also dealt with several long periods of deflation, or falling prices. And while decreases in prices could be construed as positive for the consumer, deflation is bad news for businesses and economies broadly. It's a signal that businesses have lost pricing power, and that demand is likely falling. Another value of negative interest rates is that they also help spur inflation. And a healthy inflation rate -- say, in the 2%-to-3% range -- is suggestive of a strong and steady economy.

And, in case you were wondering, Japan isn't alone. Switzerland and Sweden have also imposed negative interest rates.

Fed Chair Janet Yellen. Image source: Flickr user Day Donaldson.

Three dangers of a negative interest rate policy While encouraging lending and a potential rise in inflation are the upsides of a negative interest rate policy, there are also three big dangers of a NIRP.

First, negative interest rates discourage saving and interest-based investments. It's highly likely that banks would further reduce interest paid to account-holders on checking and savings accounts, and it's quite possible that CD yields would drop further. Even with inflation tame for the time being, low CD yields would almost ensure that ultra-conservative investors would be losing real purchasing power from the money placed in those assets.

In another context, negative interest rates penalize those among our nation's seniors and baby boomers who felt victimized by the 2007-2009 stock market crash, and who still don't have the stomach to invest in thevolatile stock market again. Often loaded with interest-dependent investment options like CDs and savings accounts, these individuals could find it very difficult to grow their wealth, and some may not hit their retirement goals.

Secondly, financial institutions being penalized by central banks are likely to pass the costs on to their customers by imposing higher fees. If banks are going to be charged by a central bank for hanging onto cash, but they remain leery about lending, they may instead boost high-margin fees to raise additional cash. Monthly charges for maintaining a checking account, higher fees for wire transfers and overdrafts, fees for out-of-network ATM usage, and even fees to see a teller as opposed to using an ATM, could come into play and rise. In fact, many of these fees have been rising, on average, over the past couple of years, whether you realize it or not.

As icing on the cake, U.S. News & World Report noted last March that some banking customers in European markets where lending rates are negative are actually paying interest to their banks!

Image source: Pixabay.

The final danger of a NIRP is that it may encourage more speculative investing, which in turn could increase market volatility.

If investors can't generate any return on investment by parking their money in CDs or savings accounts, they may grow more desperate for sources of income appreciation. Although investing in the stock market has been shown to be a good source of income generation over the long term, not all investors have that long-term mindset. What might happen is a considerable rise in risk-taking among investors, which could correlate to an increase in volatility in equity prices.

One smart way to counter negative ratesIf these dangers demonstrate anything, it's that a NIRP may not be a cure-all for the U.S. economy. Nonetheless, in the somewhat unlikely event that the Fed does choose to adopt negative interest rates, there's a pretty simple solution that should allow investors to generate real wealth and sleep well at night. This solution? Buy high-quality dividend stocks.

As long as you can add brand-name businesses with superior yields to your portfolio, you should be able to generate income above and beyond the rate of inflation. On the flip side, the strength of a business' brands, and a recurring dividend, afford you the patience to wait for an eventual economic turnaround. High-yielding names like AT&T, Philip Morris International, and Johnson & Johnsonaren't going anywhere just because lending rates may one day move into negative territory, and the dividend income they provide can potentially fuel inflation-topping wealth generation.

The article 3 Dangers of a Negative Interest Rate Policy originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.