Negative Interest Rates - Never Say Never

Updated February 2014

Now that the ECB is discussing the possibility of setting a policy of negative interest rates, this article from the New York Fed becomes even more pertinent, particularly as key central bankers around the world have painted themselves into a policy corner.

An interesting article out of the New York Federal Reserve entitled "If Interest Rates Go Negative....Or, Be Careful What You Wish For" takes a look at the scenario of negative interest rates and how these rates would impact the economy and consumers.

As shown on this graph, for each of the eight recessions that America has experienced over the past five decades, the Federal Reserve has used falling interest rates (in red) to prod the economy back to life:

Notice that, since 1980, the background interest rate during expansions (in green) has dropped to lower and lower levels, most notably in the period since 2008 when interest rates were pushed to near zero.  Despite that, the economy is barely growing and unemployment remains elevated.  This has led some people to suggest that the Fed should push short-term rates into negative territory, yet another experiment along with the already ineffective QE and Twisting.

The Fed could best accomplish this by charging interest on excess bank reserves rather than paying interest.  The Interest On Excess Reserves or IOER currently sits at 0.25 percent.  It is this rate that is the benchmark for Treasury Bills, commercial paper and interbank lending.  By lowering this rate further or pushing it into negative territory, banks would have less incentive to keep deposits with the Fed and may be more willing to loan the funds thereby stimulating the economy. 

According to the authors of the analysis, Kenneth Garbade and Jamie McAndrews, IOER rates below negative 0.50 percent would present problems for banks because their products and services would be used in ways that are not expected.  As cash from money market funds flooded into banks, they would likely be forced to charge depositors for holding onto their cash, essentially creating a negative yield.  The Bank of New York Mellon has already taken steps toward charging a fee to depositors with large cash balances as shown here.  As well, demand for certain Treasuries would spike as investors sought yield, pushing the price up and yields down further, resulting in even greater distortions in the bond market.

Here are some of the impacts of negative interest rates and tactics that consumers and businesses may use to avoid losing money on their savings:

1.) Some analysts suggest that negative rates are not possible since investors will choose to hold cash.  While that may be possible for smaller investors like you and I, it is not possible for corporations and various levels of government who would be holding billions of dollars in physical currency.  That said, smaller businesses and individuals who elect to hold cash would pressure the Treasury Department to print more physical currency as demand for paper bills rose.

2.) Special-purpose banks would likely be created.  These banks would offer conventional checking accounts for a fee and would pledge to hold no assets other than cash, held in a vault.  Checks written on these banks would essentially be a receipt on the cash held by the bank.

3.) Individuals may choose to make large excess payments to the IRS, counting on collecting the overpayment the following April.  This would avoid losing money on negative interest unless, of course, the IRS implemented a negative interest rate policy on overpayments.

4.) Individuals may also choose to make large excess payments on their credit cards, running down the balance as they make purchases.

5.) Rather than depositing checks received from governments, businesses or other individuals immediately, recipients may find it more prudent to avoid negative interest rate charges by simply not cashing the checks immediately.

6.) Consumers and businesses will have more incentives to make payments on outstanding credit balances quickly over a shorter period of time and receive payments on such credit balances more slowly over a longer period of time.  This is completely contrary to the current system that demands payment on credit as quickly as possible.  This will pose problems for a system that has evolved in an environment where "time is money".

As we can see from this analysis, a Federal Reserve-implemented negative interest rate environment would result in an intriguing set of issues for the American economy, the banking sector and consumers.  While it is highly unlikely that such an environment will occur, ten short years ago, no one would have ever thought that the Fed would have pushed interest rates down to a fraction of a percent for a three year period.  

Never say never.

Yet Another 2012 Election Prediction Tool

Updated November 5th, 2012

An interesting website, NerdWallet, founded by Tim Chen and Jacob Gibson in 2009, has just published its most recent outcome prediction for the 2012 Presidential election.  I realize that everyone and their dog has an analysis that predicts a November winner but I found this one intriguing.  Here is a summary of Joanna Pratt's analysis.

Let's start out with what the analysis uses as its baseline.

1.) President Obama has 201 safe electoral votes.

2.) Mitt Romney has 181 safe electoral votes.

3.) The winner needs 270 electoral votes out of 538 total. 

There are 12 states with a total of 156 electoral votes that could go to either candidate.  To get the 270 votes, Mitt Romney needs at least 89 of those 156 electoral votes or 57 percent of the total to win.  Here  is a chart showing the 12 states in play, the current polling numbers and the statistical odds of winning each state:

Right now, the margin of error in polling is 5.5 percent according to NerdWallet, a margin of error that was statistically gleaned from the 2004 and 2008 elections.

The computer simulations run using the current polling results and polling accuracy suggests that, at this point in time, Mitt Romney will win only 250 electoral votes, a number that is short of what is needed to win the Presidency.  Note, as well, that this is well down from 257 electoral votes just two days ago.

To summarize, here is a pie chart showing the odds of winning the election based on NerdWallet's analysis:

Basically, Mitt Romney's chances of getting the 89 electoral votes that he needs to win is only 19.7percent, compared to 79.5 percent for the incumbent President.  Keep in mind, however, that on November 1st, the odds of Mr. Romney taking the necessary votes was 31.3 percent so, it would appear that the momentum has swung in favour of the incumbent.

Tuesday November 6th will tell whether Ms. Pratt's analysis is correct.

The Hurting Households of Europe

Nearly every day, we read some grim news about Europe's economy.  The August 2012 edition of the ECB Monthly Bulletin shows that European households are having a difficult time.  A handful of graphs will show you where the problems lie.

To help keep the importance of household consumption into perspective, the ECB states that in the first quarter of 2012, Europe's GDP was 2365.1 billion euros.  Of this, household final consumption expenditures were 1364.3 billion euros or 57.7 percent.

First up, here is a graph showing annual percentage changes as a percentage of gross disposable income for household income and consumption growth and savings ratio :

Real disposable income declined by 0.5 percent on a year-over-year basis.  Consumption (dashed brown line) grew by a modest 1.9 percent annually, close to income (solid blue line) growth of 1.8 percent over the same one year period.  The savings ratio (dashed green line) has dropped to near-decade lows of 13.3 percent, down from nearly 16 percent during the peak of the Great Recession.

The net worth of households continues on its downward slide as shown here:

The net worth of households declined on the back of falling real estate prices; over the past four quarters, household net worth has declined by 4.9 percent of gross disposable income.  As you can see from the purple line on the graph, the change in net household worth has swung to the negative side for the first time since the end of the Great Recession.  The household debt-to-assets ratio reached a historical peak of 14.5 percent as a result of relatively low savings and decreases in the value of non-financial assets.

Despite massive intervention by the ECB and the Bank of England, households definitely are not feeling the wealth effect from their domestic stock market portfolios:

Consumer confidence is, not surprisingly, "below its long-term average" as shown on this graph:

This signals that consumers simply are not willing to spend as is reflected in shrinking total retail sales data (solid blue line).

Lastly, let's look at Europe's employment picture.  In June, the unemployment rate across the Eurozone hit 11.2 percent, an increase of 1.2 percentage points over a year earlier despite the fact that this is supposed to be a post-recession recovery.  These two graphs show that further job losses are anticipated in both manufacturing and non-construction employment and that the losses appear to be accelerating:

Here is a graph showing the unemployment situation:

Unemployment expectations for 2012 stand at 11.2 percent, rising to 11.4 percent in 2013 and falling back slightly to 10.8 percent in 2014, hardly stellar and well above what both the United States and Canada are experiencing and expecting.

For those who are still working, here is a graph showing how compensation in some countries continues to drop when compared to the euro area:

You will notice that workers in both Greece and Spain have seen their wages fall back to the levels that they were at in 2002 and that Ireland is back to levels that it experienced back in 2004.

When you see all of this data in one place, it make you realize why things in Europe look so grim.  What is even more frightening is that in today's global economy, all of our markets are intertwined.  The United States and the European Union have the largest bilateral trade relationship in the world with the U.S. investing three times as much as they invest in all of Asia and the EU investing eight times the amount in the U.S. that they invest in India and China.  Approximately 15 million jobs are linked to the transatlantic economy.  In the case of Canada, the EU is its second most important trading partner after the United States, accounting for 10.4 percent of Canada's total external trade.  Thirty-four percent of Europe's imports are sourced from Canada.

From this posting, I hope that you will realize how important the health of Europe is to the rest of the world's economy and, in particular, how important it is that Europe's households remain fiscally secure. After all, in our consumer-driven economy, households are key.

Has America's Real Estate Market Turned A Corner?

Fiserv has now released its analysis of the United States housing market.  Here are a few of the salient points from their summary accompanied by my usual commentary.

Let's open by looking at the most recent Case-Shiller chart of national home price indices showing that things finally appear to be turning a corner:

Fiserv notes that the U.S. housing market is finally showing some signs of stabilizing.  Home prices in 151 markets or 39 percent of the 384 metropolitan areas tracked by Fiserv Case-Shiller showed an increase in the first quarter of 2012 compared to a year earlier.  That noted, price declines of 1.9 percent were noted on average across the U.S. and are forecast to decline another one percent over the next twelve months.  On the upside, prices are expected to appreciate by 5 percent between Q1 2013 and Q1 2014!

Price appreciation was noted in Detroit, and Michigan (up 8.6 percent) and Miami, Florida (up 6.4 percent), however, this has to be taken into context since these areas have seen peak to trough price declines well in excess of 50 percent.  In sharp contrast, double digit price decreases were noted in Atlanta, Georgia (down 17.4 percent), Las Vegas, Nevada (down 7.4 percent) and Memphis, Tennessee (down 4.7 percent), all on a year-over-year basis, largely because these markets are still flooded with foreclosure properties.

Fiserv notes that inventories of single-family homes has dropped below 2.5 million, the lowest level since 2004.  This shrinking supply is nudging prices upwards, however, the large number of homeowners with negative equity is impacting many markets.  Many markets that experienced price crashes are now seeing far lower inventories of foreclosures, putting modest upward pressure on prices.

The 35 to 40 percent drop in prices over the past 6 years has resulted in the ratio of the price of a median single family home to median family income at its lowest point since 1991.  In fact, for those lucky Americans that are not underemployed or unemployed, the mortgage payment for a median-priced home now consumes only 12 percent of a median family's income, the lowest percentage since record-keeping began in 1971.  From FRED, here is a graph showing housing affordability back to 1980, noting, of course, the recent drop in affordability:

So we can all better understand this graph, here's how FRED measures housing affordability:

"Value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home. An index above 100 signifies that family earning the median income has more than enough income to qualify for a mortgage loan on a median-priced home, assuming a 20 percent down payment. For example, a composite housing affordability index (COMPHAI) of 120.0 means a family earning the median family income has 120% of the income necessary to qualify for a conventional loan covering 80 percent of a median-priced existing single-family home. An increase in the COMPHAI then shows that this family is more able to afford the median priced home."

Fiserv notes that the biggest risk to the housing market is the stalling world economic recovery and the risk of another political impasse in Washington over debt and deficit reduction.

Fiserv suggests the following:

1.) Investors and buyers looking for home price appreciation should head west since eight of the top ten markets projected to grow fastest in the next year are located in Oregon, Idaho, California and Washington.  

2.) The housing market in Florida continues to be bleak with eleven of the 20 metro areas seeing home prices falling the most over the next year.  The state is home to four of the ten worst markets and four of the ten best markets based on projected changes in housing prices over the next five years.  Orlando is projected to see an additional 6.8 percent drop over the next year and Jacksonville will see an additional drop of 3.3 percent.

Fiserv projects that between the first quarter of 2013 and the first quarter of 2014, 358 of the 384 metropolitan housing markets (or 92 percent of the total) will see price increases.

Only time, the unemployment situation, interest rates, the political games in Washington, a slowing world economy and the debt crisis in Europe will tell whether Fiserv’s projections are wanting.