By Olumide Owolabi, Portfolio Manager, Global Fixed Income Team
The Fed seems more likely to focus on a range of policy tools.
Neuberger Berman's Global Fixed Income team recently conducted a roundtable discussion focused on the unprecedented dynamics of negative interest rates. We examined historical precedents in an effort to better understand potential costs, benefits, effectiveness and short- and long-term implications of central bank negative rate policies. Most importantly, we considered not only the possibility of the Federal Reserve adopting a negative interest rate policy (NIRP), but also whether the U.S. Treasury yield curve is susceptible to finding a home below the zero lower bound.
Our conclusion: The Fed is highly unlikely to push overnight interest rates into negative territory, primarily because it has a significant and effective toolkit of preferred options if easier monetary policy is required. That said, longer-term interest rates are increasingly driven by central bank actions in Japan and Europe, and if those central banks push rates further into negative territory, it is possible - although unlikely - that longer-term U.S. yields could move below zero.
Negative-yielding assets have become a concern with the size of global negative-yielding debt exceeding a $16 trillion threshold, accounting for around 30% of the market value of the Bloomberg Barclays Global Aggregate Index, and entire yield curves of some countries in negative territory. Yields have been moving lower recently, as investors expect easier monetary policy out of the ECB, in particular, given deflation risks and heightened levels of exogenous risks around European politics.
Figure 1: Demand for Duration Spikes with Global Uncertainty
(Source: Bloomberg, Neuberger Berman)
In our roundtable, we first explored the history and characteristics of negative interest rates as a policy tool. Since the Global Financial Crisis, policymakers have been grappling with a mix of low inflation, weak resource utilization, and sluggish and inconsistent economic growth. Despite exhausting almost all monetary policy options in the toolbox, the lack of persistent results has vaulted NIRP into the mainstream of policy options. Central bankers in Denmark, Switzerland, Sweden, Japan and the euro area have set short-term rates below zero, hoping to further stimulate economies with perceived levels of excess slack.
To date, it's fair to say that negative interest rates - and savers' paying to invest their money - have not deeply impacted the household sector. While, in theory, negative interest rates may incentivize savers to hold currency or cash, practical limits or storage costs mean that households continue to hold deposits in banks. If households have generally not been feeling the impact of negative interest rates, the same cannot be said of the banking system. Banks are paying negative interest rates on their excess deposits, and the impact of this cost is affecting bank profitability, reflected in their equity prices. As shown in Figure 2, euro area and Japanese banks have underperformed when compared to the broad equity markets in those regions.
Figure 2: Historical Bank Performance Adjusted for Broader Equity Index
(Source: Bloomberg, Neuberger Berman)
Negative Rates in the U.S.?
With level of yields across the globe this low, and the current uncertainty around trade tensions and their impact on global economic activity, it's natural for investors to wonder whether the Fed will consider negative interest rates as a monetary policy tool. A handful of both former and current Fed members have said they explored the possibility during the Global Financial Crisis but decided against implementation on the back of staff analysis pointing to an imbalance in potential cost versus benefits to the U.S. economy. Here, we try to analyze the potential risks that kept the Fed from adopting a negative rate policy during the Global Financial Crisis and explore if anything has changed, as we now have a benefit of other central banks' history.
- Money market funds: One of the bigger concerns both then and now is the impact of NIRP on the money market fund industry, which is larger in the U.S. and plays a very important role in financial intermediation in the financial system. U.S. money market funds maintain a stable net asset value, and negative interest rates would call into question this foundational investment for many households.
- Bank profitability: The deep negative sentiment that could arise from charging retail depositors negative rates, as evidenced in Europe, has handicapped banks from passing through losses accrued on central bank reserves to retail depositors. If banks are unwilling or unable to pass along the costs of negative interest rates to their depositors, negative interest rate policy effectively acts as a tax on the banking system and reduces its capital base, potentially undermining the desired stimulative effect of lowering rates.
- Legal constraints: It's uncertain whether the Federal Reserve Act authorizes the committee to either pay negative earnings or use its power to impose fees and charge negative interest rates on excess reserves.
- Risk of the unknown: Despite implementation by other central banks, the history is quite short and the U.S. financial system is similar to no other in terms of size and complexity; policymakers are rightly concerned about unintended spillover impacts.
However, perhaps the strongest reason to be skeptical about negative rate policy in the U.S. is the Fed's conviction - which we at Neuberger Berman share - that alternative policies can achieve the Fed's objectives without many of the risks noted above. In our opinion, the Fed will almost certainly rely on the following mix of policies, if needed, rather than pursue negative rates:
- Interest rate adjustment: The current short rate is in the 2.0-2.25% range, giving the Fed reasonable scope to reduce rates back to zero, if needed.
- Forward guidance: In many ways, negative interest rates are simply a form of strong forward guidance - a Fed commitment to very easy monetary policy. The Fed seems more interested in a policy mix of zero interest rates with some type of strong forward guidance, such as a commitment not to raise rates unless certain economic objectives are achieved, rather than applying negative rates. Such a policy mix would likely achieve desired economic results with less risk than negative interest rates.
- New asset purchase program: The Fed's balance sheet is currently around 18% of nominal GDP, which is greatly reduced from its 25% level in Q3 2018 and far less than the ECB's current 40% figure. As such, the Fed has considerable room for quantitative easing, including the purchase of various asset types.
- Yield curve control: This tool was made popular by the Bank of Japan (BOJ) and has since gained support within the Fed (among both previous and current members). In the BOJ's case, long-term rates were pegged but the Fed would more likely target short- to intermediate-term rates (i.e., starting a peg of one- to two-year rates and extending further along the curve if needed). This methodology would not only buy the committee much-needed time to evaluate the impact of easy monetary policy on economic activity but strengthen its forward guidance tool.
Beyond these considerations, a white paper presented at the Fed's June 2019 Conference on Monetary Policy Strategy, Tools and Communication Practices1 concluded that NIRP is less effective when a central bank's balance sheet is larger, and could, in fact, become mildly contractionary. This conclusion, which Fed members broadly agreed with, further supports the view that negative interest rate policy is low on the Fed's hierarchy of potential tools.
Despite what we consider the negligible probability of near-term NIRP implementation by the Fed, we are not dismissing the possibility that the U.S. yield curve could temporarily venture into negative territory.
With a persistent decline in the neutral real interest rate (Figure 3) due to changes in structural factors such as lower trend growth, weaker productivity growth, an increasing global savings glut, an aging population and low global inflation, estimates of the term premium for long-term Treasuries (Figure 3) have crossed into negative territory. If a sustainable pick-up in inflation does not take place, an investor's motivation for holding a long-term bond suddenly switches from that of compensation for inflationary risk to insurance against deflation. In this scenario, when one incorporates the global scarcity of long-duration assets and the attractiveness of longer-term U.S. rates to foreign investors (particularly in Japan and Europe) due to a currency-hedged yield advantage, the probability of a negative-yielding curve rises significantly. Though not our central scenario, we acknowledge this possibility as U.S. rates trends lower.
Figure 3: U.S. Neutral Rate and Term Premium of 10-Year U.S. Treasury Yield
(Source: Federal Reserve Bank of New York, Neuberger Berman)
What we have learned so far from the short history of NIRP is mixed at best. Economies that implemented this policy approach experienced an initial bounce in financial conditions, economic activity and inflation dynamics, but the gains did not last long.
Considering such middling results, we are left wondering whether we are witnessing the limitations of monetary policy, highlighting key realities:
- Monetary policy is not only about sizing but also of timing. Mistakes or inactivity at the wrong time can be very costly, as evidenced in the case of the euro area and Sweden, which are paying for the consequences of their policy error in raising rates sooner than necessary in 2010-2011.
- Monetary policy can only do so much, and needs to be combined with fiscal policy to get the right effect in certain economic situations that show signs of structural breakdown. As witnessed in this cycle, the key driver that has kept inflation down and economic activity unresponsive is a system-wide deleveraging by both corporations and individuals. A sustainable change seems to be beyond the control of central banks; rather, it rests with the ability of governments to renew investor and consumer confidence and elevate the ability to spend.
Finally, the proliferation of negative short rates has left a critical question unanswered: At what level does the short-term nominal interest rate become an ineffective monetary policy tool? The pre-GFC answer would have been zero, but market participants no longer seem sure, as an effective lower bound has replaced the zero lower bound. In the Fed paper referenced above, the authors note that "there exists a cutoff negative policy rate below which financial intermediaries would voluntarily choose to exit. [They] refer to this cutoff rate as effective lower bound (ELB) and find that it can be quite close to zero for an economy in which the central bank carries a large balance sheet." So, given the choice of either NIRP or a package of policies including zero rates, new quantitative easing and stronger forward guidance, our strong view is the Fed would pick the latter.
1 Sims, Eric R. and Wu, Jing Cynthia, "Evaluating Central Banks' Tool Kit: Past, Present, and Future," NBER Working Paper.
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