Federal Reserve officials as recently as December envisioned being on track for a second increase in interest rates next month.
Halfway into February, however, they have lost control of the conversation. The talk this week was about the possibility of the Fed lowering rates, not raising them.
Fed officials projected in December that they would raise short-term interest rates four times in 2016 to follow up on the rate increase that month, which increased the target range from 0-0.25 percent to 0.25 percent-0.5 percent.
Now, markets see no chance of that happening. Instead, bond market futures suggest that the Fed won’t raise rates again until mid-2017 at the earliest.
And events have conspired to raise questions about whether the Fed could actually lower short-term interest rates to below zero.
The question has been raised because of falling stocks and other negative indicators that suggest the risk of a recession is rising. The Bank of Japan surprised investors two weeks ago by announcing it was moving one short-term interest rate below zero. And the Fed earlier in February required banks to consider the possibility of negative rates in the scenarios it laid out for their annual “stress tests” that measure how they would hold up in a crisis.
For those reasons, Fed Chairwoman Janet Yellen faced a number of questions about the possibility of negative interest rates from lawmakers when she gave her semi-annual monetary policy testimony in the House and Senate this week.
Yellen testified that the Fed was “looking at” the possibility of negative interest rates as a matter of preparing for the possibility of a downturn, but that it wasn’t on the agenda. She also said she didn’t know if the Fed had the legal authority to set negative rates.
The mere suggestion that negative interest rates could be a possibility has caused a markedly unfavorable reaction in a public that has conjured up fears of the central bank effectively charging banks to hold onto their money.
“I find it very, very disturbing to even seriously consider moving in that direction,” Sen. Pat Toomey, R-Penn., told Yellen.
In a note posted in the bond giant’s site, PIMCO investor Scott Mather warned that the Fed “may be warming to the idea,” of negative rates, “having gone beyond supportive innuendo to subtle preparation for potentially engaging” in it. He warned that zero-rate policies elsewhere in the world had already driven up volatility.
At least one member of the Fed was frustrated to see the Fed’s cautiously laid out plans being disregarded in exchange for fears that they are going to reverse course and lower rates below zero.
“I just find that an extraordinarily premature conversation to be having,” William Dudley, president of the Federal Reserve Bank of New York, said at a press conference Friday.
“If things were to turn in a surprising direction and the outlook in the U.S. were to deteriorate really sharply there are a lot of things that we would do long before we would really think about moving to negative interest rates,” Dudley said, “so for me that is not something that should be part of the conversation right now.”
In past years, the Fed has turned to “forward guidance” —ssádddd promising lower rates for longer — and buying longer-term bonds as the tools for easing money, rather than lowering short-term interest rates below zero.
The Federal Reserve Bank of Atlanta has calculated what the effects of those policies would be in terms of the short-term rate, estimating a “shadow rate” that represents what the short-term rate would be if it could go below zero, based on the interest rates on long-term Treasury bonds. By their measure, the shadow short-term interest rate has been negative since nominal rates hit zero in late 2008, reaching as low as negative 3 percent in 2014 during the Fed’s stimulus efforts.
In other words, while the Bank of Japan, the Swedish Riksbank, the Swiss National Bank, Denmark’s Nationalbank, and the European Central Bank have all experimented with negative rates, the Fed is not likely to follow suit.
As Yellen explained to members of the House, the Fed’s reluctance to consider negative rates ” isn’t just a question of legal authority. It’s also a question of: Could the plumbing of the payment system in the United States handle it? Is our institutional structure of our money markets compatible with it?” she said. “We’ve not determined that.”
Yet other Fed members’ comments indicate that it is a remote possibility.
Speaking at the Council on Foreign Relations in New York earlier in the month, Fed Vice Chairman Stanley Fischer walked through the reasons why central banks have been able to institute negative rates when banks presumably could just convert their reserves to cash.
“If you’re going to keep your billion dollars in currency, you’re going to have to find a place to store it, you’re going to have for that, you’re going to have to insure it, and you’re going to have to have it guarded. And by the time that’s done …. zero is no longer the lower bound,” he explained.
Citing the fact that other central banks have pushed rates below zero, he said that “it’s working more than I can say that I expected in 2012.”
Yellen herself didn’t speculate about negative rates directly. But in her House testimony, she acknowledged that cutting rates from the current 0.25 to 0.5 percent rage was a possibility if the economy went bad.
“I don’t think it’s going to be necessary to cut rates, but that said, monetary policy, as I said, is not on a preset course,” she explained. “And if it turned out that that would be necessary, obviously the [Fed] would do what is needed to achieve our goals that Congress has assigned to us.”
