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Federal Reserve Indicates Willingness to Employ Negative Rates

Posted by Steve Markowitz on October 12, 2015

For months the Federal Reserve (Fed) has been “threatening” to increase interest rates from the historic lows.  To date the Fed has come up with a myriad of excuses in delaying any increase.  Given the bubbles created in certain parts of the market including worldwide equities, it is likely that the Fed fears that a rate increase would pop the bubbles leading to significant economic dislocations.

In a world where macroeconomic rules have been turned on their heels, the Fed has floated a trial balloon that is diametrically opposed to their purported goal of increasing rates.  As reported by MarketWatch.com, some in the Fed have indicated a willingness to go to negative interest rates during the next economic crisis; i.e. recession.  In a nutshell, those that put cash in the bank would lose a small percentage of that cash each year, instead of obtaining interest, the historical norm.

New York Fed president William Dudley said in an interview last week: “Some of the experiences [in Europe] suggest maybe can we use negative interest rates and the costs aren’t as great as you anticipate.”  He went on to state: “We see now in the past few years that it has been made to work in some European countries,” and “so I would think that in a future episode that the Fed would consider it.”

It is likely that Dudley’s comments were not a slip of the tongue, but instead a trial balloon to see how markets would react to a radical economic move.  While there has been some softening of the US dollar and increases in commodity prices such as gold, the response has been muted, exactly what the Fed hope for.  This helps demonstrate how far off of economic reality we have come.

Interest RatesTo help put things in perspective, the Federal Reserve refused to implement negative interest rates during the 2009 meltdown, the worst economic calamity since the Great Depression, for fear of the consequences.  The fact that they would consider such action today helps demonstrate just how fragile the Fed views the economy.

The central banks have used historically low interest rates since the 2009 meltdown, as indicated in the attached chart.  Pushing rates to negative returns is a continuation of this policy, although now breaking a psychological barrier, whose goal is to stimulate the economy through increased consumption.  This low interest rate policy has been a failure, which is being confirmed by the Fed’s willingness to go even further.  Why should we expect this additional step would be more successful?

A negative interest rate policy will have unintended economic consequences.  However, there are consequences that are rather easy to foresee:

  • Lower savings for individual Americans will make them even more vulnerable to the consequences of recession.
  • Inflicting economic pain on retirees and others on fixed incomes.
  • Cajoling investors into more risky investments in search of returns.
  • Significantly damaging those dependent on money markets.
  • Decreasing return assumptions for pension plans that will force managers into more risky investments and require additional injection of funds to keep the plans solvent.

New York Fed Chairman Dudley would be willing to pursue the radical negative interest rate policy based on the fact that some European countries have implemented it without major consequences.  However, Dudley ignores the fact that the US dollar is the world’s reserve currency and therefore has broader implications.

We are now approaching the eighth year since the economic meltdown.  We were told that the Fed’s low interest rate policies will repair the damage.  We also have been told by our government that all sorts of stimulus programs and deficit spending would repair the economy.  Both failed, which has resulted in the Federal Reserve announcing the possibility of still more radical programs.  A more prudent approach would be a realistic review of the implemented policies and determine why they failed before implementing more of the same.  But this small piece of logic is either lost on the Fed or they feel that they have no alternative.  Neither offers confidence in the Fed’s ability to navigate these complex issues.

 

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