The Fed shot down the notion of negative US interest rates last week—again. Yet the market continues to stubbornly price them in. This is a mistake, right? It probably is, but the thought process behind this behavior is actually sound.
If the US economy remains weak into 2021, the Fed will need to ease more. With official short-term rates already at zero and quantitative easing (QE) going full throttle, it isn’t clear what other tools the Fed will use. Until the Fed’s next steps are clearer, investors have no obvious way to price additional easing measures.
That’s why the market seems obsessed with pricing negative interest rates: it’s actually a way to express a view that the Fed will need to do more to support the US economy over the next few years as it works its way back from the impact of the coronavirus crisis. Viewed that way, the logic behind pricing in a Fed move to negative rates makes sense to us, even if we think negative rates themselves are unlikely.
A breakdown of Fed chair Jerome Powell’s remarks last week illustrates a couple of key reasons the Fed might reach the point where it needs to dig deeper into the policy toolbox:
1) The Fed learned that it can—and must—run the labor market more tightly than it thought possible. The seemingly trivial link between unemployment and inflation, based on recent experience, makes this possible. And those at the bottom end of the income distribution will only benefit from the economic expansion if the labor market is run hot.
2) It might lose ground in lifting people in or near poverty if there’s no V-shaped rebound. A central bank study showed that 40% of all households making under $40,000 per year lost a job in March—with more likely in April. It took years for those households to benefit from the last expansion, and if they can’t get back to work quickly, we could see a repeat—with huge societal and economic costs.
3) The Federal Open Market Committee (FOMC) expects the economy to recover quickly, but not with a “V.” While Powell expects unemployment to fall rapidly later this year, he also sees a stretch of several years before the US economy returns to its previous level. Essentially, Powell is worried about a weak recovery from this unprecedented shock.