Why the Fed must go negative on interest rates

The Bank of Japan surprised the world late last week when it decided to use the nuclear option of monetary policy to stimulate its stagnant economy … negative interest rates. Japan joined eight other countries whose central banks, or treasuries, are charging customers to hold their money.

Switzerland and Sweden are among several countries with rates below zero. In Germany, anyone who buys a German bund, (bond) pays the government for the privilege of lending Berlin money. From the shortest maturities, out to seven years, German bunds are sporting negative yields.

Negative interest rates
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This has been, throughout monetary history, an extremely rare phenomenon, but it is becoming increasingly commonplace, as the world fights both recession and deflation simultaneously.

Negative interest rates are used when policymakers want cash to be lent, or spent, and not saved. Effectively, it is a tax on deposits that make lending and spending far more appealing options than losing money, every day, on the cash you put in the bank, or into government bonds.

With Japan, home to the third largest economy in the world, unleashing this dramatic policy tool, the consequences are not just domestic but global.

Japan, long a nation of savers, needs to be a nation of lenders and spenders if it hopes to grow its way out of persistent recession and deflation.

After Friday's announcement, the Japanese yen plunged against the dollar, further strengthening the greenback at a time when the Federal Reserve has begun to raise interest rates.

Fed policy, for many reasons, some justifiable, some not, is now grossly out of step with the monetary policies of the world's other major central banks. Put more simply, the Fed is tightening (or normalizing), while the rest of the world is easing.

That sets up a scenario in which there are but a few potential outcomes, none very promising.

First, the Fed continues to raise rates, weakening an already decelerating a U.S. and global economy. That pushes the dollar higher, commodity prices lower, weakens U.S. exports, and cuts into the profits of U.S. multi-national corporations, exacerbating a profit recession in corporate America.

Such continued intransigence on the part of the Fed, ignoring the accelerating weakness of nearly all of our major trading partners, would materially raise the risk of recession here at home, and exacerbate the one abroad.

Virtually all of the world's major countries except China and Mexico are in recession, whether led by a contraction in manufacturing, or by the bust in commodities.

Second, the Fed may simply choose to hold off on raising rates until there is more clarity on the outlook for the global economy.

But even the simple act of doing nothing, as other central banks ease further, would strain foreign exchange values, accelerate capital outflows from countries whose currencies are plunging against the dollar, and rapidly increase the debt servicing costs of those countries - like Russia, China and other emerging markets, which have heavy dollar-denominated debt loads.

In other words, if global monetary policies continue to diverge dramatically, there will likely be unintended consequences that lead to a rupture in world markets, strained by wildly fluctuating currency values, a further crash in commodity prices and a rush of capital out of the world's weakest economies.

Some reports have suggested that China has seen $1 trillion (that's trillion with a "T") exit the mainland, while emerging market economies have witnessed similar capital flight.

If that trend were to worsen, it would likely lead to a financial panic, a deep global recession and even more deflation, a vicious cycle for which there may be no immediate, nor obvious cure.

The Fed should, given recent events, simply admit its error of pre-emptively raising rates before both its employment and inflation mandates had been met, and reduce the Federal Funds rate back to zero, pending further improvements in the economy. Certainly, the Federal Reserve risks its credibility by admitting an error, but that is a far better outcome than risking recession by not doing so.

While I am hopeful the Fed will halt the rate hikes for the foreseeable future, I am less optimistic the Fed will fully reverse course.

This delay may simply postpone the inevitable, negative interest in the U.S. as well. In one sense, Wall Street, Main Street and Washington are not fully prepared for such a dramatic move. While many may view this development as a buying opportunity for stocks, it may signify an environment in which monetary policy is no longer the cure for what ails us.

Commentary by Ron Insana, a CNBC and MSNBC contributor and the author of four books on Wall Street. Follow him on Twitter @rinsana.

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