With a tweet, President Trump has reopened the debate about negative interest rates.
In Japan and Europe negative rates are a fact. And just last week former Federal Reserve Board Chair Alan Greenspan said in a televised interview that he believes negative interest rates will hit the U.S. before long.
Federal Reserve Bank of Dallas President Robert Kaplan has said he’s skeptical whether negative interest rates are “viable.” Former U.S. Treasury Secretary Larry Summers also opposes the idea. Federal Reserve Bank of Minneapolis President Neel Kashkari in 2016 said it’s "unlikely" the Fed would implement negative rates. Fed Gov. Lael Brainerd also dismissed the possibility in a televised interview earlier this year.
On the other hand, Federal Reserve Bank of St. Louis President James Bullard has said negative rates could be considered at some point.
Probably the most telling sign that Fed policy makers are not yet considering negative rates is that they still refer to zero lower bound, suggesting zero is the bottom. And there is a question about whether such a move would be legal.
“Negative interest rates aren’t a scenario to wish for,” said Greg McBride, chief financial analyst at Bankrate.com. “They’re still in the experimental stage and it’s not proven if they even work. The countries that have negative policy interest rates aren’t exactly teeming hubs of economic activity – they’re reeling, which is how they got to negative rates in the first place.”
The markets would face issues in such conditions. “There are legitimate concerns about whether markets would function properly in an environment of negative rates, particularly short-term money markets,” he said. “It flips the banking business model upside down. What happens to the flow of capital and availability of credit in those scenarios aren’t known – and let’s hope we don’t have to find out.”
Even if the Fed goes to negative interest rates, “it's not necessarily true that municipal bond yields would also go negative,” according to Peter Ireland, a professor of economics at Boston College and a member of the Shadow Open Market Committee. “But it is likely that negative policy rates would cause yields on municipal bonds to decline, and this might help a bit, in offsetting fiscal pressures at the state and local level. That would clearly be a beneficial side effect, to offset some of the problems.”
Speaking to the more general question of whether negative interest rates should be considered by the Fed, Ireland said, “as part of a contingency plan, negative rates shouldn't be ruled out.” But, he added, negative rates “have adverse effects on savers and could lead to distortions in financial markets.”
Former Fed Chair Janet Yellen downplayed the possibility of negative interest rates, and suggested “other tools like forward guidance and asset purchases should be considered first.”
The effect on bond insurers “is less clear,” Ireland said. “That is because the way that a bond would pay negative interest is not by requiring the holder to send in payments instead of receiving interest payments; instead, it would be because the original bond sells for a price that's above face value so that, even given the regular interest payment, the yield accounting for the loss the bond holder will suffer by paying more than face value, is negative.”
“What would really hurt bond insurers is a replay of what happened in 2008, where large numbers of borrowers all go bankrupt or threaten to default at the same time,” he said.
While not dismissing the use of negative rates at some point, Payden & Rygel Chief Economist Jeffrey Cleveland said, “I think some investors have gone too far in expecting the U.S. to follow the rest of the world to negative rates in the near term.”
Treasury-bill yields were negative “at various points in 2011, 2014 and 2015 – albeit briefly in each instance,” he said.
Although the risk of recession has increased, the firm doesn’t expect one in the next 12 months. “Global economic activity appears to be bottoming, and the U.S. consumer remains resilient.” And central banks’ policy easing this year should work its way through the economy by yearend and into next year. “Once again, the bond market might have swung too far in the pessimistic direction,” Cleveland said.
Should the Fed pursue negative rates, he said, “there would be some important structural conditions for the Fed to wrestle with.” For example, “the U.S. financial system depends on money market funds to intermediate credit. Negative rates would impair the money fund industry and hurt credit intermediation, reducing or disrupting economic growth. In short, NIRP medicine would be worse than the disease.”
It's a mixed picture, according to Marc Joffe a senior policy analyst at Reason Foundation. While negative rates would
In a tweet, Diane Swonk, chief economist at Grant Thornton, said, “Market participants would likely view such a drop in rates as a signal that the economy is much weaker than it appears, which runs the risk of triggering a panic and self-fulfilling recession.”
Others shared this view. If the Fed were to cut rates to zero, “this would steepen the curve, stoke inflation fears, and give at least a short term boost to the economy,” said Hugh Nickola, principal and head of fixed income at GenTrust. “In this scenario, the Fed would only be able to maintain negative interest rates in the very front end of the yield curve so the effects on the U.S. economy would be quite muted.”
But, if the situation worsened and more accommodation was needed, “then negative rates could indeed become a reality here as the Fed would do whatever it could to stimulate growth. In this case, the ramifications to the financial markets and the financial industry could be more significant.”
Still, he added, “Negative rates have existed in Europe since 2014 and in Japan since 2016 without causing major harm to the financial system.”
In reality, the Fed has worried “pushing rates too low … could cause a flight to cash which would obviously disrupt the financial system if left unchecked.”
“Slower growth would clearly weigh on the financial strength of bond insurers since it would lead to a weakening of muni credits as tax receipts stagnate,” Nickola said. “Negative rates would also drive down the investment income of the insurers, though this would be at least partially offset by declines in borrowing costs.”
Edward Moya, senior market analyst, New York at OANDA, said, “President Trump's frustration is hitting a fresh record high as the ECB is about dive even deeper into negative territory, while the Fed seems poised for a painstakingly slow cutting cycle. The Fed will do what they need to defend their mandate and that will require lower rates, possibly a return of QE, with worst case scenarios seeing helicopter money.”
Volatility will continue in the bond market thus year. Given the low fed funds rate target (2% to 2.25%) and the fact the Fed usually cuts rates about 500 basis points in a downturn, its toolbox looks “rather depleted,” he said. “Many bond investors seem convinced the U.S. will see negative rates just like Europe and Japan, but a lot will have to go wrong with the global economy for that to happen. Before we see negative rates in the U.S., we would likely see the Fed work with other central banks and possibly alongside government in a profound coordinated effort to bring back inflation. If the Fed has multiple critical policy mistakes, the risks grow that they could lose their independence.”
In his opinion, “a global recession and a Fed policy mistake” would be precursors of negative rates. He predicted low rates will remain “for the coming decades,” given “the size of U.S. “How low will rates go will depend on how stubborn the Fed remains in committing to an easing cycle,” Moya said. “If we don't see at least a full percentage point worth of rate cuts over the next six months, the bond market will likely help drive the 10-year yield well below the record low level of 1.318%.”
CPI
The consumer price index rose 0.1% in August after a 0.3% gain in July, while to core rate grew 0.3% both months, the Labor Department said Thursday.
Economists polled by IFR Markets expected a 0.1% rise in the headline number and a 0.2% gain for the core.
Year-over-year, CPI was up 1.7% and the core increased 2.4%, the largest rise since July 2018, compared with projections of 1.8% and 2.2%. The gain in inflation shouldn’t stop the Fed from the expected 25 basis point rate cut next week.
Jobless claims
Initial jobless claims fell to 204,000 in the week ended Sept. 7 from 219,000 the week before, Labor reported. Continued claims slipped to 1.670 million in the week ended Aug. 31 from 1.674 million a week earlier.
