Goldman Asks If Negative Rates Are Coming To The US

While looking at data provided by Eurostat reveals a picture of positive European growth and vibrance, what central banks on the ground are saying is something totally different. And indeed, after yesterday's surprising move by Sweden's Riskbank, there are now at least four central banks, and numerous countries in Europe, that are toiling under NIRP: Sweden (-0.1%), Denmark (-0.75%), the Eurozone (-0.2%) and, of course, Switzerland (-0.75%). Japan, oddly enough, has so far resisted the temptation to join Europe in an all out NIRP-fest, however with the amount of bonds the BOJ is monetizing, which is just about 100% of net JGB issuance, NIRP would be a secondary tool in the BOJ's arsenal especially since Japanese bonds drift in and out of negative interest rate territory on a whim. But what bout the US?

Well, as we first noted a week ago referencing a long-forgotten piece by NY Fed authors titled appropriately enough "If Interest Rates Go Negative . . . Or, Be Careful What You Wish For." As could be expected at the time, the Fed was full of fire and brimstone warnings about the aberations that would occur in a world in which negative rates prevail. It even went so far as saying that "we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation."

Well, the financial innovation has yet to come, but Europe is doing all it can to accelerate its arrival.

However, now that Europe has demonstrated that one can go NIRP and not crash the system, will the Fed - once its silly obsession with hiking rates in the summer only to launch even more easing and/or QE as the ECB did in 2008 and 2011 - follow suit and join a rising tide of "developed" world central banks in punishing savers for hoarding cash?

In a note released last night titled "Revisiting Negative Interest Rates in the US", Goldman shares its thought on the matter. It goes without saying that Goldman is important, because whatever Goldman's econ team shares with Goldman's Bill Dudley over at the NY Fed, usually tends to become official policy with a 3-6 month lag.

Revisiting Negative Interest Rates in the US


Central banks in Europe have pushed short-term interest rates further into negative territory recently. Today, the Swedish Riksbank cut its repo rate to -0.1%. The Danish central bank—an early pioneer in negative short-term interest rates—moved its deposit rate down to -0.75% last week. The Swiss National Bank pushed deposit rates into slightly negative territory after it abandoned its currency peg to the euro in December, and has since moved the target range for 3-month Swiss franc LIBOR to -1.25% to -0.25%. The European Central Bank has been holding its deposit facility rate at -0.2% since September. These developments have raised investors’ interest in the feasibility of negative interest rates in the United States, however remote the possibility.


Would the Fed adopt negative interest rates?


We think it is unlikely that the Fed would want to implement negative interest rates in the US. Most importantly, Fed officials have continued to suggest that rate hikes are likely to start in mid-2015, and pushing interest rates into negative territory would of course be moving away from rather than toward rate hikes. (Our forecast for the first hike remains September 2015.) However unexpected negative shocks could always occur. Even then, we think the Fed would be more likely to effect any dovish shift in its policy stance through forward guidance (whether formal or informal) or balance sheet policy, rather than a move toward negative interest rates. 


The question of whether the Fed should cut the interest paid on excess reserves (IOER)—which has stood at 25 basis points since December 2008—has come up a number of times in recent years. Usually the question has been posed in terms of whether IOER should be cut to zero, rather than cut to a negative rate, although the fundamental issues are similar in either case. As we have written in the past, we think the Fed is fairly confident that the benefits of cutting IOER would be small, but the costs are highly uncertain. As a result, they have taken a risk management approach and pursued other ways to ease policy after reaching the zero lower bound. 


In Janet Yellen’s first semiannual monetary policy testimony as Chair last year, she said that cutting IOER to zero could potentially “completely disrupt money market activities,” while Chairman Bernanke in 2010 noted that if rates went to zero, money markets might not “continue to function in a reasonable way.” The two key concerns here are probably: (1) the operation of the fed funds market and (2) the impact on money market mutual funds. 


Regarding the fed funds market, the Fed has reaffirmed that it will continue using the effective fed funds rate as its policy target in the future, and as such would probably be reluctant to do anything to further dry up already thin activity in the market. Against this concern, one might argue that EONIA trading volume—the Euro area equivalent of the effective fed funds rate—did not drop sharply after the ECB instituted slightly negative interest rates in September. However, trading in central bank deposits has a somewhat different character between the US and the Euro area. Much of the volume in the fed funds market is motivated by institutions eligible to earn IOER (banks) borrowing excess liquidity from those ineligible to earn IOER (non-banks). As a result, cutting IOER could be expected to significantly reduce market activity. In contrast, EONIA already only covers bank-to-bank transactions. 


Money market funds are probably the more important issue from the Fed's perspective. The US money fund industry is different from its European counterpart for a number of reasons. First, money market funds are larger and play a more important role in financial intermediation in the US than they do in Europe, which has a more bank-centric financial system (Exhibit 1). Second, US money funds are less likely to be backstopped by a more diversified bank sponsor than are European funds. Third, US money funds maintain a stable net asset value (NAV) while European money funds maintain a floating NAV (although last year's SEC money market reforms are moving prime institutional funds to floating NAV). Some observers have argued that the stable NAV misleads investors into believing that money fund investments are riskless, and as a result, might make funds more susceptible to runs in the event of losses. For these reasons, the Fed might be worried about creating a situation where the US money fund industry suddenly finds it increasingly difficult to profitably exist in its current form, and results in a potentially disruptive reconfiguration of the current financial plumbing.


Exhibit 1. Money Funds Are Bigger in the US



Finally, there are significant "systems issues" that would need to be overcome if the Fed were to push short-term interest rates into negative territory. Treasury bills can currently only be auctioned at a discount or at par value, not at a premium. In addition, the minimum coupon on a Treasury note or bond is 1/8%, and negative yield bidding is not allowed for nominal securities. While if push came to shove we believe these issues could be overcome, just as they were with "Y2K" for instance, the implementation cost could be substantial and there could be scope for unwelcome surprises.

So assume the Fed takes the hint, and after one more year of failing to stimulate benign inflation, it decides to take the nuclear option, "how negative could short-term rates go"? Again, Goldman's take:

Even if they do pierce the zero "lower bound" (ZLB), there is a natural limit on how negative short-term rates can go. Banks have the option to convert central bank reserves to physical currency, and depositors have the option to take their deposits out of banks in the form of physical currency. If savers are penalized with negative interest rates, they will eventually prefer to hold currency. Indeed, demand for physical currency in the economy is generally accepted to be related to the level of interest rates even in more normal times. Once the Fed cut interest rates to near-zero currency in circulation grew significantly faster than its pre-crisis trend (Exhibit 2 left panel). On a more micro level, a study from Boston Fed authors Briglevics and Schuh (2013) found that the demand for cash "held in wallet" by consumers (specifically those without credit card debt) was both interest rate sensitive and nonlinear (Exhibit 2 right panel). As rates fall to zero, cash held in consumers' wallets increases at a disproportionate rate. And cash held in wallet is normally only a small share of currency held by households. In fact, most of the increase in currency outstanding in recent years has occurred in $100 bills, which are less likely to be used for day-to-day transactions.


Exhibit 2. Cash Holdings Are Rate-Sensitive



But the cost of holding cash is not zero either. As our European team has analyzed in the past, there is an implicit negative "cash yield" due to the cost of safety deposit boxes (in the case of individuals), secure warehouses or vaults (in the case of institutions), insurance, etc. for physical currency holdings. Because of this, there is no reason why short-term interest rates cannot be slightly negative, especially if negative rates are assumed to be temporary. Perhaps this is why ECB President Draghi described -20 basis points as the "effective lower bound" on its policy rate, and indicated that rates "cannot be adjusted down further" (although SNB and the Danish central bank maintain more deeply negative policy rates).

Actually, that does not explain why both the SNB and the Danish Central Bank are toying with the idea of NIRP going to -1% or lower next. The only question is when does the Fed join the deliberations.