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After the announcement of QE3, which seems more like QE infinity, can the next stimulus be negative interest rates on reserves parked by banks at the Fed? This article discusses the probability of such a stimulus and its implications for the economy and asset classes.

The idea of negative interest rates is not new and has been discussed as a stimulus option by central bankers. Most recently, James Bullard, St. Louis Fed President stated that he sees potential benefits from imposing negative interest rates on the excess reserve banks currently park at the Fed. From a central banker's perspective, there are several reasons to consider this option as a stimulus.

As of August 2012, US banks had nearly $1.5 trillion of excess reserves parked at the Fed. The banks are paid 25 basis points on these reserves. Even this rate seems attractive for banks when it comes to getting risk free returns.

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Further, QE3, which involves monthly purchase of $40 billion of mortgage backed securities, will provide more liquidity to the banking system. If the mortgage buying plan does continue until mid-2015, nearly $1.3 trillion of additional liquidity will flow into the banking system.

In a sluggish economic environment with high unemployment rate and high consumer leverage, banks would continue to deposit cash at the Fed instead of increasing their lending to households or businesses. Therefore, even if interest rates remain near-zero levels until mid-2015, credit growth in the economy might remain muted.

The primary objective of negative rates on reserves would be to discourage banks to park money with the Fed. Again, from a central banker's perspective, the idea is to spur credit growth, which might boost the money velocity (currently at its lowest since the 1960's).

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On the face of it, the idea might seem innovative or workable. However, there are issues related to the feasibility and usefulness of the idea.

By having negative interest rates on reserves, the economic scenario for businesses and consumers does not change. The banking system's perception of risk associated with lending would therefore remain the same. In such an event, banks would prefer to invest in the Treasury market (for risk free returns) than increasing their lending.

On the positive side, Treasury bond yields will trend even lower if $1.5 trillion of cash or more is invested in Treasuries. Lower yields will reduce debt service cost for the government and help them raise further debt at attractive rates.

On the flipside, households and business would not gain much out of this. Household debt has declined by $1.3 trillion from its peak in the third quarter of 2008, and the process of deleveraging is expected to continue.

Households would only leverage if the unemployment scenario improves along with an improvement in the overall business sentiment. I don't see that happening anytime soon. As such, there would be no real benefit if interest rates on reserves are negative.

On the contrary, negative interest rates on reserves would be more harmful than beneficial for households. If banks do have to pay on their deposits with the Fed, the deposit rates for households will also take a hit.

Policymakers might argue that no returns on deposits would encourage spending by consumers. However, in a fragile economic environment, I see consumers holding on to cash or speculating in asset classes (to generate positive returns adjusted for inflation) rather than going on a spending spree.

Further, a bigger problem for the banking system might arise if consumers start to withdraw their savings from banks due to low or negative returns. The current scenario might not be the best time for this nature of capital erosion for banks.

In one of the recent articles in the Federal Reserve Bank of New York blog, the unusual impact of having negative interest rates is discussed. Soome key points are presented below for readers.

Nevertheless, if rates go negative, the U.S. Treasury Department's Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.

For example, a taxpayer might choose to make large excess payments on her quarterly estimated federal income tax filings, with the idea of recovering the excess payments the following April. Similarly, a credit card holder might choose to make a large advance payment and then run down his balance with subsequent expenditures, reversing the usual practice of making purchases first and payments later.

We might also see some relatively simple avoidance strategies in connection with conventional payments. If I receive a check from the federal government, or some other creditworthy enterprise, I might choose to put the check in a drawer for a few months rather than deposit it in a bank (which charges interest). In fact, I might even go to my bank and withdraw funds in the form of a certified check made payable to myself, and then put that check in a drawer.

As interest rates go more negative, market participants will have increasing incentives to make payments quickly and to receive payments in forms that can be collected slowly.

In conclusion, the article states that:

The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive-even if individually beneficial-financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.

Very clearly, there are more cons than pros in having negative interest rates on excess bank reserves.

Having said this, the Fed can implement this idea in a scenario where credit growth and lending is not showing any signs of improvement even at near-zero interest rates.

Further, the Fed is very much in an experimental mood as it tries unconventional methods to fight of the worst crisis since the great depression of 1929.

From an investment perspective, the idea is inflationary as its objective is to bring out the $1.5 trillion of excess reserves into circulation in the economy.

This is in line with the policymaker's objective of having a steady dose of inflation in the economy. I do suspect that inflation will be much higher than what policymakers expect or plan.

In any case, inflation targeting is not the best of ideas as inflation is a pretty dynamic process.

Negative interest rates can also boost gold prices as investors and consumers use gold as a store of value than paying for their deposits and losing further to inflationary pressure.

Holding physical gold would be a preferable option. Investors can however also consider gold ETFs as an investment avenue. The SPDR Gold Shares ETF (GLD) would be a good investment option.

With the same rationale, silver would also be a good investment option and it has the potential to match the returns of gold or even outperform in the long-term. Investors can consider exposure to silver through the iShares Silver Trust (SLV).

I have also maintained my view that equities will tend to do well in times of inflation. Further, US corporate sector is globally diversified and can perform relatively well compared to US economic growth. Index investing would be a good idea for investors not particularly keen on stock picking.

The SPDR S&P 500 (SPY) ETF would be a good investment option with the ETF generally corresponding to the price and yield performance of the S&P 500 Index.

Source: Negative Interest Rates On Reserves: The Right Or Wrong Stimulus?