Is The U.S. Heading Toward Negative Rates?

Today, almost $13.5 trillion, or 27% of bonds in the world are trading at a negative yield, but few view this as a normal scenario. Most of that debt has been issued in Europe and Japan, reflecting central banks’ unconventional efforts to restore growth and ignite inflation by forcing rates below zero. Even President Trump seems enamored. Recently he tweeted in favor cutting interest rates to zero or less. 

In Europe, banks have kept deposit rates above zero for retail consumers, fearing that households may simply withdraw their funds and hoard cash if faced with negative rates. As the banks look to avert a profit squeeze, they have snuck in more fees and tried to keep lending rates up. Nevertheless, bank profits are hollowing out and some banks, such as UBS, BNP Paribas and Deutsche Bank, are struggling with shrinking margins. 

Negative rates in Europe are unlikely to be a precursor of what’s coming to the U.S., but future recessions may test every central bank’s appetite for unconventional easing, including the Fed’s. 

Not A Cure-All For The Economy

In 2016, former Federal Reserve System (“Fed”) chair Ben Bernanke, reflected on the potential for negative U.S. rates. In his modelling and hypothetical scenarios, he concluded there were modest benefits to such a policy, as eventually depositors and institutions start hoarding cash. There are also potential legal constraints for the Fed, as it is not clear that the bank can charge negative rates. And beyond that, the disruption it would have on money market funds that play a more significant funding role in the U.S., versus Europe or Japan.  

While Bernanke acknowledged that some of the issues could be resolved, he felt that moving to extreme rates – similar to some countries in Europe – could be counterproductive. The likely scenario where he felt modest negative rates could contribute would be as a quick fix when rates are already at zero, and the Fed wants to signal some accommodation but not roll out a full Quantitative Easing (QE) program.  

Even so, the success of utilizing negative rates to invigorate an economy seems dubious. First of all, the track record is short. The European Central Bank (ECB) adopted negative rates in June 2014, while the Bank of Japan (BOJ) started in January 2016. Second, it is hard to evaluate if the economy would have been gloomier without them. 

In looking at the empirical link between low rates and inflation, the conclusions from Japan are instructive. Research from its experience in the middle of the 1990’s, when inflation sputtered and the BOJ moved to trap rates close to zero, shows that this aggressive policy was ineffective in pulling inflation up

Other research that focused just on the negative policy experiment that began in 2016, confirms more disappointment: inflation expectations actually fell. In this case, Japan’s inflation expectations were already anchored at a low level, so cutting rates into negative territory backfired as it raised concerns that growth was deteriorating.   

In bank lending activities, negative rates do not always make it grow. Some studies from the ECB found that banks that are highly dependent on deposits are reluctant to shock customers with negative rates. Many floor deposit rates at zero, temper lending and seek to make up income through riskier investments.

Other ECB research which compared shifts in lending from pre- to post-negative interest periods, found that banks that are highly dependent on deposits but who also carry large excess reserves tended to lend more in a negative-rate environment. The decision to lend more or invest in other securities may come down to differences in a bank’s scale and sophistication, which leads to an inconclusive result of how well negative rates fire up lending. 

Certainly low rates may not entice businesses or consumers to borrow. If rates are negative because growth is lagging then companies and households may stall fearing the economy is heading for a rough patch.  

Will The U.S. Adopt Negative Rates?

Central banks have been forced post-financial crisis to shepherd the recovery as fiscal stimulus has generally been muted. To make more progress with unconventional easing from here or to arrest a recession, more fiscal stimulus will be needed. Monetary policy in negative regimes may have finally reached its limits.

This is something that ECB chief Mario Draghi reiterated several times as he rolled out his updated monetary program. At a minimum, the ECB is running out of bonds to buy for its asset purchase program. If Eurozone countries don’t target more spending then the ECB can’t expand its bond buying. 

Outside of a recession, therefore, it is difficult to see the U.S. dabbling in negative rates. Certainly, all tools could be in play in a serious downturn, but forward guidance and targeted QE would be the first order of business. The danger with prolonged negative rates is they could slowly disrupt financial institutions. Expect the Fed to learn from these lessons, and not rush to repeat them.   

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.

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