Federal Reserve To Test Negative Interest Rates

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Includes: RINF
by: Global Risk Insights

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In a recently released annual report, the Federal Reserve issued rules for stress-test scenarios that include a move to negative interest rates. While the report is careful to categorize the scenarios as merely hypothetical, investors would be prudent to seriously consider what such a stress-test may reveal about the Fed's thinking after a jolting start to the year for global markets.

Mandated as part of the Dodd-Frank Wall Street Reform Act of 2010, the Federal Reserve requires US banks to perform annual financial readiness drills, or stress tests, in which they subject their capital structures to multiple economic situations outlined by the central bank.

The scenarios in the recent report range from baseline to adverse and severely adverse and all start in the first quarter of this year. It is the severely adverse hypothetical for 2016 that describes a steep dive into recession, unemployment levels hitting 10%, and a subsequent move by the Fed that takes interest rates down to negative .5%.

Economic weakness is not limited to the US for this scenario, as it incorporates "severe recessions" across the developed economies of the Eurozone and Japan, with more mild contractions across Asia. Deflationary forces push consumer prices down markedly and the stock markets may endure a 50% sell off.

Even though the scenarios described are purely hypothetical, the purpose of the tests is to ensure that big US banks can survive the 'what ifs' generated by current economic conjecture. In this way, the severely adverse option may represent the worst of what the Fed thinks could happen in 2016. It would also represent a tectonic shift in US monetary policy.

Re-routed?

After raising interest rates above zero for the first time since 2006 in December of last year, world capital markets opened the New Year with a historic thud. In the weeks since, the futures markets have all but eliminated the chances of additional rate hikes for 2016 as Fed Chair Janet Yellen stated concern over global risk developments, such as the volatility in China and the deepening crisis in Brazil.

Originally emboldened by a seeming 'Goldilocks' economic recovery and intent to finally raise rates off the zero bound, the Fed forecasted up to four interest rate hikes in 2016 despite easing policies from central banks around the world. The divergent move looks increasingly like a mistake as the first rounds of economic indicators in the US and abroad have come in tepid at best.

The 'R' word is not just being whispered now, it is being screamed by some of the big banks themselves. So after a meager rate increase to 0.25%, has the negativity received through the economic feedback loop changed the Fed's thinking on rate policy going forward?

While a move to negative interest rate policy (NIRP) would be a first in the US central bank's history, they would not be the first to the NIRP party. The European Central Bank and several sovereign European banks within the region have moved to negative key interest rates and held them there for over a year and counting as an effort to fight deflationary forces and stimulate economic activity.

Most recently, Japan made a flashy entrance to the NIRP party as the Bank of Japan shocked the financial world with a move to negative rates last week.

These examples serve as case studies for the Fed as it closely observes others' experiences with the formerly unprecedented financial policies. And now the Fed is testing US banks for such a policy under a severe recessionary scenario.

Until recently, the Fed was viewed as being short on options if the US entered recession while rates were already at or close to zero. The stress test results and drawing from experiences abroad may give the Fed the audacity to embrace negative interest rate policies and change the calculus on just what exactly the central bank has in its tool kit.

So does the Fed see a 50% market crash and a global recession in our future? Not likely, but what it does see is ever more ways to manipulate domestic and global capital markets in order to keep assets and markets aloft should they encounter turbulence. The biggest political risk is that central bank policies, in an effort to stave off collapse, continue to separate markets from economic realities so completely that investors lose confidence in both and the collapse becomes self-fulfilling.