Should the Fed consider negative interest rates?

The debate over the use of negative interest rates continues.

“Given the low level of interest rates in many developed economies, negative interest rates could become an important policy tool for fighting future economic downturns,” Jens H.E. Christensen, a research advisor in the Federal Reserve Bank of San Francisco Economic Research Department, wrote in a recent Economic Letter.

“Analyzing financial market reactions to the introduction of negative interest rates shows that the entire yield curve for government bonds in those economies tends to shift lower,” he writes. “This suggests that negative rates may be an effective monetary policy tool to help ease financial conditions.”

This, he said, “suggests that the ultimate effective lower bound for short-term nominal interest rates is significantly below zero, at least for the five economies considered here.”

The use of negative rates, if they are effective, could add to central banks’ toolbox at zero lower bound. But the Fed, and Chair Jerome Powell, have downplayed the possibility of using below-zero rates.

“Federal Reserve policymakers have not expressed support for using negative interest rates in the next recession, preferring to rely on asset purchases and forward guidance,” said Steven Friedman, global macroeconomist, MacKay Shields, Global Fixed Income Team. “The apparent lack of support likely stems from uncertainty over the cost-benefit tradeoff of negative rates, along with potential political risks. Committee members would not relish the prospects of explaining to Congress the use of a policy lever that is often misconstrued as imposing costs on retail depositors.”

With interest rates at a low level worldwide, central bank options are limited. “As central banks approach the zero lower bound, monetary policy begins to lose its mojo,” said Michael Reynolds, investment strategy officer at Glenmede. “There appears to be diminishing returns to cutting policy rates around negative territory. Sluggish growth in economies that have dipped into negative rates, like Japan and the Eurozone, are a prime example.”

While some of those nations have structural issues to deal with, “overall, negative interest rates have not been the white knight that boosts economic growth to a significant degree,” he said.

While low interest rates offer incentives for businesses and individuals to spend, if the expectation is rates will stay “low for the foreseeable future,” there is no urgency to borrow today.

“To the extent that lower yields on benchmark bonds translates into lower discount rates and costs of capital, negative interest rates can contribute to asset price inflation,” Reynolds said. “In particular, growth stocks tend to be some of the larger beneficiaries of lower yields, since their expected cash flows tend to be further out into the future and thus more interest-rate sensitive.”

“Negative interest rates are a bit like the Rebel Alliance in Star Wars: you genuinely have no idea how it eventually works out,” according to Sebastien Galy, senior macro strategist at Nordea Asset Management.

“Negative interest rates force investors into riskier asset classes, such as credit,” he said. While at first, this may produce positive impact, eventually excesses occur.

“The issue is when leverage builds up excessively in the lowest tranches in High Yield, accidents do happen and if fears of a recession come back, they typically are faced with a potential liquidity crunch,” Galy said.

Central banks have “a limited set of tools — a set of tools that may no longer be fit for the job that they are asked to do,” said Brian Rehling, co-head of global fixed income strategy for Wells Fargo Investment Institute. “In fact, it could be argued that the current set of global central-bank tools is actually counterproductive, at least when it comes to negative interest-rate policies.”

Despite these limitations, the monetary policy will “still have an impact, at least for now,” he said.

Negative interest rate use in the U.S. “is highly unlikely,” and the Fed has said it would revert to quantitative easing, when at the zero lower bound. “In fact the Fed now considers such bond buying actions as part of its normal policy going forward,” Rehling said. “Yet, we question just how effective such action would be, given that the Fed still has more than $3.5 trillion in bonds on its balance sheet.”