Could the Federal Reserve turn to negative interest rates in the future?
By Kathryn Jackson Fallon
The European Central Bank has already adopted them, and so has the Bank of Japan. In today’s topsy-turvy, sometimes bizarre world of finance since the Wall Street financial crisis, recent precedents have been set for a central bank to adopt negative interest rates.
“They’ve opened Pandora’s box,” says Craig Dismuke, chief economist with Vining Sparks in Memphis Tenn., ICBA Securities’ exclusively endorsed broker for community banks.
Could the Federal Reserve Board of Governors actually adopt a negative interest rate policy for the United States? It’s unlikely, but certainly possible if another major economic downturn happens, Dismuke says.
To be clear, Dismuke considers it unlikely that the Federal Reserve would set a negative interest rate policy—where it would set its benchmark interest rate below zero. The U.S. economy is stronger, and the Federal Reserve has already begun, though haltingly, to try to raise interest rates. But several other central banks have set precedents recently by setting negative interest rate policies to generate an economic recovery.
Earlier this year the Bank of Japan unexpectedly set a deposit rate of negative 0.10 percent for some of its bank reserves. The European Central Bank cut its main lending rate to negative 0.10 percent to stimulate activity in 2014, then to negative 0.30 percent in 2015, and most recently to negative 0.40 percent in March.
Switzerland, Sweden and Denmark also set negative interest rates to curtail capital inflows from their countries between 2009 and 2010 during the recession.
However, negative interest rate policies are not just a farfetched but also an untested monetary tool. As far back as 1972 to 1978, Switzerland used a type of negative rate policy to limit capital inflows from other countries and to fight against inflation mounting around the world. Nonetheless, the Swiss Franc still appreciated 75 percent during the period.
The theory behind negative interest rates is that they could generate economic growth by making new credit and capital investment less expensive. The value of loans and other financial assets would in theory increase, and U.S. exports would become more competitive as our country’s currency also devalued if the Federal Reserve adopted a negative interest rate policy.
Nevertheless, Dismuke believes the downsides to negative interest rates would be much more significant than any theoretical benefits, including for community banks. And stinging effects, he says, would likely be manifold, such as artificially increased consumer confidence, excessive risk-taking by investors and disruptions in the financial sector (some money managers in countries using negative interest rates have cut off access to money market funds). Certainly, negative interest rates would put further pressure on already thin loan margins at community banks.
“The downside to negative rates would be much more significant than the benefits that we would see from them,” Dismuke says.
But would the Federal Reserve ever let the negative-interest-rate genie out of the bottle?
Dismuke says the possibility is exceptionally low this year, but the odds could increase in 2017 if signs of another recession emerged and the Federal Reserve’s current interest rate policy still hovered close to zero. Even in that remote scenario, he says, the runway for going negative on interest rates would be fairly long for the Federal Reserve. Months of public policy debate would take place before such a decision would be made.
Moreover, the Fed would likely try other monetary tools first before resorting to the untested track record of negative interest rates in the United States. Considering a possible trip down the rabbit hole of negative interest rates is still worth contemplating as part of any bank’s risk-management exercises, Dismuke suggests.
Kathryn Jackson Fallon is a writer in New York State.