Negative Rates In U.S. Only As a Last Resort

The imposition of negative interest rates by central banks in Japan and across much of Europe has American investors spooked that the U.S. Federal Reserve might be mulling a similar policy.

That anxious bit of speculation, combined and fueled by concerns for growth out of China and uncertainty over the recent plunge in global oil prices, has dragged U.S. stock markets perilously close to bear market territory.

The Dow Jones Industrial average was down about 75 points at noon ET, following another rough day for markets on Monday. The Dow is down about 8.5% since the first of the year and the broader S&P 500 is down 9.7% since Jan. 1.

Negative interest rates are widely regarded as a measure of last resort, to be used only after an economy has been mired in an extended period of stagnation or recession and all other stimulus tools have been exhausted.

While economists and market analysts have been raising the specter of negative interest rates in the U.S. for months, the Fed has been essentially mum on the subject.

In fact, Fed Chair Janet Yellen made it clear in November that the U.S. economy would have to take a major turn for the worse for the Fed to even consider negative rates. What’s more, Yellen didn’t bring up the topic. She was asked about it by a member of the House Financial Services committee during testimony before Congress.

In response to a question that specifically asked whether the Fed was considering negative rates in the event the economy tanked, Yellen responded, “Potentially anything - including negative interest rates - would be on the table. But we would have to study carefully how they would work here in the U.S. context.”

But what else is Yellen going to say? She can’t dismiss negative rates out of hand because, as she noted, anything is possible. At the same time she made it fairly clear negative rates aren’t anywhere near the top of the Fed’s to-do list. (Yellen and her predecessor at the Fed, Ben Bernanke, are masters at answering difficult questions about the U.S. economy and the path of monetary policy without committing to anything.)

Still, the topic has been growing fodder for analysts, especially in the wake of Japan’s decision last week to initiate the radical strategy.

Negative rates are an extreme measure deployed by central banks in an effort to push private banks and other lenders into lending money rather than stashing their excess cash in reserves generally held by central banks. Negative rates mean the private banks have to pay to stash those reserves. Indeed, negative rates are often referred to as a tax on excess reserves.

That latter reality – banks being forced to siphon away profits to pay the added cost for keeping their reserves in central banks -- has dragged down financial stocks.

“The increasing number of central banks adopting NIRP (negative interest rate policy) is weighing on the profit outlook for financial companies that now must pay to hold some of their reserves at the central bank and hurting the performance of the global financial sector,” Jeffrey Kleintop, Charles Schwab’s chief global investment strategist, said in a report.

Kleintop noted that another central bank stimulus program known as quantitative easing, in which central banks purchased massive amounts of government bonds to pump cash into ailing economies, helped push stocks higher in recent years. But negative interest rates might have the opposite effect, he said, and could eventually cut into economic growth.

Kleintop told it’s “unlikely” the Fed will initiate negative rates in the U.S. First, because one consequence of negative rates is falling currency values, which could lead to a currency war that might benefit Europe and Japan but not the U.S. Second, U.S. banks responded favorably enough to the near-zero rates initiated in 2009, making negative rates unnecessary, he said.

The only U.S. Fed official openly advocating for negative rates is former Minneapolis Fed Chair Narayana Kocherlakota, an outspoken inflation dove who regularly chided his former Fed colleagues for not providing enough stimulus in the wake of the 2008 financial crisis.

And even Kocherlakota acknowledged that “going negative is daring but appropriate monetary policy.”

At any rate, Yellen is set to appear before Congress again Wednesday and Thursday and the subject of negative interest rates is certain to come up.

Members of the House Financial Services Committee will undoubtedly remind Yellen that stocks are tumbling, the strong dollar is hammering U.S. manufacturers by jacking up the price of U.S. exports , low oil prices are slashing profits in the sprawling U.S. energy sector, and that all of these factors contributed to a weak fourth quarter GDP of 0.7%.

At which point Yellen will almost certainly repeat her position of last November: no policy, she will say, including negative interest rates, is off the table should the U.S. slip back into recession. Should being the operative word.