It often doesn’t take much to scare financial markets, and the way that they interpreted Fed Chairman Jay Powell’s comments on the prospects of negative interest rates proves this.
The very idea of a central bank lending money to banks at negative interest rates is a very recent one, and one that isn’t even that easy to get your head around for a lot of people. This does indeed involve the Fed paying banks positive interest instead of charging negative interest when banks borrow from them, which does seem strange.
When interest is charged on loans, this requires that we weigh the costs of borrowing with the benefits that the loan provides us. When we collect interest to borrow, there are benefits on both sides for us now, where the benefit of collecting interest from borrowing can be itself enough incentive to do it, even if there aren’t any benefits otherwise to borrow it.
Negative interest rates therefore encourage us to borrow as much as they will lend us, and if we ever rolled out such a thing to the public, people would max out their borrowing capacity even if they were receiving no interest on the money, because they would be basically paid to borrow.
There are usually plenty of things that folks would buy if they had the means, and when you get paid rather than pay to borrow, this will definitely drive up consumer spending. Lower rates do this to some degree, but this effect would be even more pronounced.
With negative central bank rates, people or even companies don’t get to borrow at these rates though, and whether or not banks can borrow at negative rates, they aren’t going to share this with their clients. They might have been paid to borrow it but they will not dilute this profit by ever offering out loans at negative rates, but this certainly can serve to reduce their own borrowing costs and allow banks to lend at lower rates than before.
Depositors are also not going to put money on deposit with banks and pay negative rates to do so, even if they want to put their money on deposit at a bank. There are other things to do with it, and even if they insist on it being held at a bank, they could buy a safety deposit box and do so for a nominal annual fee.
Negative central bank rates do therefore drive borrowing and the money supply like putting these rates down do, to a certain threshold at least, to the point where there is still interest charged on these loans. We can get close to zero but can never get there, and especially get below zero, so there is a limitation to lowering rates no matter how low a central bank may want to go.
As rates go down below zero, we also encounter a diminishing effect of this stimulating borrowing. When rates are already extremely low, a quarter point reduction will have less effect upon borrowing than when you do this when rates are higher, because as rates lower, the potential lending market shrinks because they have already extended their capacity from the lower rates.
The reason why bank rates can never go to zero or negative is that there has to be a sufficient benefit for banks to lend, and zero rates provide no benefit. There are costs to extending loans, including risk of default, and there is always risk with any loan. No matter how much the Fed is willing to pay banks to lend them money, starting at zero, we need to add these costs in plus a profit level deemed sufficient to find the floor to bank rates, due to a number of factors including the room left to this rate floor based upon practical considerations.
What happens when a central bank lowers the rate they charge banks below zero, these further rate cuts lose efficiency, as the amount of additional borrowing that this stimulates in the economy is proportionately less than cutting rates to non-negative rates.
It is not that the Fed’s rate is actually zero, as the Fed rate operates in a quarter point range, which is why we see it described as 0%-0.25%. The Fed does still charge positive interest, and this is more like rates as low as 0% but no higher than 0.25%. In the history of the U.S. Federal Reserve, they have never gone below this, and the firm expectation remains that this will continue, in spite of what some people may believe.
When Chairman Powell told us that there are no plans by the Fed to lower the rate further and go into the negative, he didn’t swear on his mother’s grave that this would never happen on his watch, which disturbed some people it seems and caused the market to take a hit that day, and bank stocks to take an even bigger hit.
Bank stocks are under enough pressure from real fears, and are ground zero in this financial crisis like they were during the last one, even though the damage from this one won’t be direct like last time, with the crisis itself being one of losses due to loan defaults.
The loan defaults themselves were the crisis last time, whereas this time around, the risk is from the collateral damage that the economic shutdown is causing. The other major form of collateral damage, the reduction of money supply caused by the shutdown, is already being very well managed, and money supply has increased, not decreased, during the economic crisis.
We Need to Understand What Rate Cuts Do Before We Get Scared
We can’t understand the consideration of negative Fed rates without understanding why the Fed cuts rates in the first place, and the sole reason is to use rate cuts as a tool to manage money supply. This is clearly not needed now, although this is not to say that there could never be a scenario so dire that negative rates would be on the table in the United States, and therefore it would be too much to expect Powell to say never here, but he did come as close as we may ever reasonably expect him to when he told us that they do not foresee the need for this.
Central banks in Europe and Japan did see the need for negative rates, well prior to this crisis, and whether or not this has been a good idea, the Fed does not have to depend on rate cuts to beat back contractions in money supply at times where this would not be desirable, like right now.
The Fed also has a lot more ability to use quantitative easing (QE) than other jurisdictions do, their buying treasuries to raise the money supply, and this all has to do with the much greater demand for U.S. treasuries than with other sovereign bonds. The U.S. treasury market is so robust that the Fed can execute massive QE like they are doing and treasury yields can still remain well in the positive.
In contrast, in several other countries, their QE has driven their sovereign debt into the realm of negative yields, and when you reach this point, you also see the same phenomenon that you get when you use negative overnight rates, where effects on stimulating the money supply diminish. When you can stimulate money supply enough while keeping treasury yields and the Fed rate out of the negative, there is no reason to go negative in the first place, independent of whatever collateral effects this may involve.
The Fed also has the Treasury itself behind them, and in this arms race, the United States is a true economic superpower. Congress can write multi-trillion-dollar checks with the stroke of a pen, on a scale that well surpasses anything else that the world has ever done, and fiscal stimulus of this magnitude has powerful effects upon the money supply.
If not for fiscal stimulus, we would have seen a huge decline in our money supply during the lockdown, even with anything the Fed could have done. The Fed has already done all it can without going below zero, and the marginal benefits of going below zero is simply overwhelmed by the massive fiscal stimulus that has been implemented lately by Congress.
There is currently neither the need nor any good reason for the U.S. Federal Reserve to cut rates further, so when Jay Powell tells us that there is not, there are no good reasons not to believe him, or even good reasons to fear this happening right now.
There are good reasons to avoid negative rates though if possible. One of the things that the Fed has had to struggle with is ensuring that there is enough liquidity in money markets, and have had to pour massive amounts of money into this already to ensure that things are kept humming along. Negative central bank rates serve to dry up this liquidity, which would in itself require that the Fed ramp up QE to respond to this, as they have done lately to combat the natural level of liquidity decline that the crisis has caused.
This might not seem to matter much, but we do need to realize that there will be a time of reckoning with all this QE and other stimulus that has been put into place, and having to add a lot more QE just to rectify the effects of negative overnight rates will add to the pain we feel later. While being able to conduct unlimited QE, this does not mean that they would wish to do so irresponsibly.
With the benefits to money supply of negative Fed rates being so marginal, with these negative rates requiring a QE response to offset the negative effect this has on credit markets, and especially with none of this needed, those who fear negative rates can rest easy and should not require Powell to place his hand upon the Bible when he tells us that this isn’t coming.
The U.S. Has Better Ways to Increase Money Supply Further if Needed
If we need more help, we can just pass another fiscal stimulus bill, and make the number big enough, and that’s exactly what is in the works, if we can manage to have the Democrats back down enough on the massive amount of socialist pork that has nothing to do with the crisis that they want to jam in, which they shamelessly want to hold us hostage with again. Another couple of trillion of fiscal spending goes much further to achieve our desired goal of stabilizing our money supply much better than negative rates ever could, by a huge margin actually when you are using numbers this incredibly large.
It’s even hard to imagine why anyone would be worrying at all about negative rates right now, if we knew even the little bit that we’ve shared with you here about this. The problem is that these folks really know very little about the issue, they just had the bad dream where this happened and they got scared, but when they woke up, they didn’t think about how likely this would be, and were just left with the fear.
The bottom line here is that while the United States could join Europe and Japan in lowering their overnight rate below zero, there is simply no reason to. This current economic crisis, being as extreme as it has been, not requiring any of this should tell us that it probably isn’t conceivable that this will ever be needed given that it isn’t this time.
Bank stocks are taking a real beating, with the recent resurgence in stocks virtually passing them by. The KBW Nasdaq Bank Index is currently down 43% for the year in spite of their joining the market in its little rally on Thursday, and sits barely above its March lows which the market in general has bounced so hard off of.
There are plenty of reasons to be bearish on bank stocks, more than enough that we don’t have to imagine threats that don’t exist and panic over them. The only real troubling thing here is the sheer lack of understanding of markets that are said to have priced in negative rate cuts now, which serves to emphasize even more the premium of actually looking to understand what’s going on and not just follow the mob without thinking much.