Negative Rates Explained: Your Bank, Your Currency, Your Future
Fed Funds futures are predicting that the Federal Reserve will lower their benchmark Fed Funds rate below zero by mid-2021. Will this really happen? Will COVID-19 be the crisis that settles all of those theoretical debates in economics class and on bank trading desks about whether it’s possible to have negative interest rates? It is important to reframe any action, especially an unprecedented one, by reminding ourselves what the Fed is trying to accomplish with its monetary policy.
As a reminder, from a monetary policy standpoint, the Fed’s statutory mandates are maximum employment, stable prices and moderate long-term interest rates. Practically, this has been simplified into two major areas of focus for the Fed: inflation around 2% and low unemployment. Inflation, for the most part, is impacted most directly by consumer demand. The more people buy, the higher prices go until businesses decide to increase the supply of whatever is being bought (see your Microeconomics 101 notes from college in that box in your basement). As a secondary effect, the more businesses anticipate demand, the more they manufacture and buy raw materials. These two represent the most common economic measures watched by market participants: the consumer price index (CPI) and the producer price index (PPI). Taken together, they also basically constitute the gross profit component of a company’s income statement – revenues minus cost of goods sold.
Taking the three easier ones first:
1. In our view, US borrowing rates won’t go negative. This is an obvious statement, as no country or investor would pay the government to take their money right now. That said, rates are so low that maybe we are wrong. A scenario in which this could happen is if people lose faith in their depositary institutions and feel their cash is safer in treasuries. Even so, an SIPC-insured custodian holding bonds probably wouldn’t be perceived as much safer than an FDIC-insured custodian holding cash, so we would also expect people to ask for physical treasury certificates to put under their mattress instead. Who said paper was dead?
2. We don’t see retail rates going negative simply because banks want to make money and won’t pay consumers to borrow without some explicit government mandate to do so. However, it is unclear how that would work. The government is better off finding other ways to give money directly to consumers. As we will discuss later, going through the banks may not be the most effective way to accomplish this goal.
3. Lastly, we don’t believe negative LIBOR rates make sense, as those represent the rates set by banks in London at which they are willing to lend to one another. Much of this is discussed later when we discuss the Fed Funds rate, which is another intrabank rate and which has an impact on LIBOR. But, historically, where LIBOR has deviated from central bank rates has been in times of bank distress, where if anything, LIBOR can go higher to reflect an implicit credit spread in the rates at which banks are willing to lend to one another.
So in this commentary, we focus on central bank rates. While we don’t intend to imply that we know all of the answers, we hope to provide readers with a framework to form their own opinions.