Get Ready For Negative Interest Rates When Next Recession Hits

Mar 19, 2019 | News

Article originally appeared on Forbes (HERE)

Wall Street is still hung up on whether the Federal Reserve will or will not raise interest rates further this year, yet for many Fed officials an even bigger question looms: What should policymakers do when faced with the next recession? The Fed pivoted rather quickly in recent months from expecting as many as four rate hikes this year to hinting at as few as none at all. That was in reaction to substantially weaker growth prospects abroad and a tightening of financial conditions at home, as confirmed in minutes to the Fed’s January meeting released Wednesday. 

With benchmark borrowing costs still in a 2.25% to 2.5% range after several increases starting in December 2015, policymakers worry about their limited ability to reduce interest rates in response to a future economic shock that causes a spike in unemployment.

The Fed has historically slashed rates by as much as four or five full percentage points in response to recession. It will clearly lack the room to do so the next time around. 

That’s why policymakers have made clear the fairly unusual but also remarkably powerful tool of asset purchases, known as quantitative easing and used extensively during and after the financial crisis of 2008, will remain on the table for future slumps. 

Also under potential consideration: negative interest rates.

Fed officials were reluctant to follow the lead of countries like Japan and Switzerland, which implemented negative rates—effectively taxes on bank deposits during the last downturn. The reasons were varied, but centered around potential trouble for money market funds, which are more predominant in the US financial system and could find it hard to break even if rates went negative. 

But a recent San Francisco Fed Letter suggests some US central bankers are warming to the idea. 

It finds negative rates could have made the Great Recession of 2007-2009 less shallow and less lengthy, potentially saving millions of jobs in the process. The downturn wiped out nearly 9 million jobs that took several years and substantial monetary and fiscal stimulus to get back. 

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“Allowing the federal funds rate to drop below zero may have reduced the depth of the recession and enabled the economy to return more quickly to its full potential,” writes Vasco Curdia, a research advisor at the San Francisco Fed’s Economic Research department. 

“It also may have allowed inflation to rise faster toward the Fed’s 2% target. In other words, negative interest rates may be a useful tool to promote the Fed’s dual mandate.”

Curdia also explains why he believes the perceived practical impediments to negative rates might be smaller than generally perceived. 

A negative interest rate “implies that savers pay rather than receive accumulated interest. This seems counterintuitive because savers can always take money out of that account and keep it in the form of cash.

“In practice, whether investors should always reject a negative rate is less clear-cut. People who hold large amounts of cash face the risk of losing it or being robbed. Banks and the broader financial system provide various tools that require investors to have funds in some form of account.

“This means that people might reasonably decide to tolerate a negative rate on their savings in exchange for those benefits. How far below zero the interest rate can go is not fully tested and may differ across countries.”

Curdia says rates need not “fall too deeply into negative territory to accomplish meaningful economic improvements.”

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