Fed appears to reverse course
Just a few months ago, the idea that the Fed would even consider the potential for moving to a negative interest rate policy (NIRP) in the US was virtually unheard of. Discussion instead centered on whether the Fed had waited too long to start rate hikes and when the Fed would finally move forward with the start of raising rates.
But then concerns about the “R” word began to grow and the Bank of Japan entered negative interest rate territory at the end of January, resulting in whispers about whether the Fed might ever consider moving to negative interest rates. And then the question was actually asked of Chair Janet Yellen during her semi-annual testimony on Capitol Hill two weeks ago. Her answer—which did not dismiss outright the potential for negative rates—gave the idea credibility.
How negative rates work
So what is a negative interest rate policy? It is simply that, instead of a central bank paying a commercial bank for its deposits, a central bank charges the commercial bank for its deposits. Negative interest rates are intended to encourage banks to lend their excess reserves rather than hoard them by making it unprofitable to keep extra cash. But negative rates, like any monetary policy, are a blunt instrument rather than a surgical tool and may not actually create an easing of financial conditions.
Banks do not have to take the excess cash and loan it out; instead they can just pass on the negative rates to their customers by charging them to deposit their money with the bank instead of paying interest on those deposits. However, there are some real drawbacks to a negative interest rate policy, not the least of which is that it suggests that a central bank may be running out of monetary policy tools—a very bad message to send to market participants.
US unlikely to go negative
There are specific reasons why the US is extremely unlikely to adopt a negative interest rate policy. To start, there are legal obstacles that the Fed has not fully explored yet. The Fed is not sure it can legally charge banks for interest on excess reserves as the wording of the Federal Reserve Act only provides the Fed the power for interest "to be paid" on reserves held by commercial banks. While the Federal Reserve Act does not explicitly forbid charging interest, this issue needs to be explored before the Fed can determine whether it is legally possible.
There are also negative implications for bank profitability at the time of an “earnings recession” for companies in many sectors in the US; the Fed may not want to exacerbate that situation given how European bank stocks have been sent spiraling downward by NIRP in the Eurozone. Further, there are political obstacles to adopting NIRP in the US. As was evidenced in Chair Yellen’s testimony, there are a lot of Fed critics on Capitol Hill—and elsewhere in the US for that matter. The Fed is unlikely to want to try something as unconventional and controversial as NIRP given the current political climate.
Implications for the dollar
In addition, another objective of negative rates is to weaken a country’s currency. While the dollar has shown significant strength in the past few years, which has negatively impacted certain areas of the US economy such as manufacturing, the US is far more capable of enduring a strong currency than other countries because of its reliance on consumer spending to fuel a majority of its growth.
There are other reasons negative interest rates are highly unlikely in the US, not the least of which is that the US economy will probably not need such a drastic measure given current economic data. While there are areas of fragility in the US economy and there is the potential for the US to import weakness from overseas, the economy still appears to be on solid footing and is even showing the potential for positive surprise. In addition, there are better monetary policy tools available for the Fed to use.
In short, negative interest rates are no panacea for the economy and financial markets. Even though the Fed may be looking into the feasibility of NIRP, the US central bank seems a very long way from ever having to use it. Right now even the likelihood of the Fed reversing its December hike is extremely low. And, while NIRP is very unlikely to come to American shores, it could still have an impact on US capital markets given that five central banks have already adopted it with the potential for more to come. That's because NIRP should weaken currencies, which could in turn strengthen the dollar—which means we should be following this situation closely. Negative interest rates on this scale are unchartered territory for the global economy. With economic and monetary policy so uncertain, one of the few things we may be quite sure of is more volatility.
About the Author
Kristina Hooper is the US Investment Strategist and Head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
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