Thursday, January 29, 2015

Negative Interest Rates - A New Reality Coming Soon to a Federal Reserve Near You?

Updated September 2015

The very concept of negative interest rates seems counterintuitive.  After all, why would you pay someone to hold your money for you?  It intrinsically seems wrong (even though we're already doing it by paying banks monthly fees for various services).

The new reality of negative interest rates came home to roost when Switzerland's central bank moved to unpeg the Swiss franc from the euro.  While that move roiled the markets, the SNB's announcement that it was dropping interest rates further into negative territory on deposits to minus 0.75 percent.  On top of that, effective January 20th, Denmark's central bank announced that it was joining the negative interest rate crowd by lowering the rate on certificates of deposit to minus 0.20 percent.  The central banks of both of these countries made the move further into negative interest territory in a move to prevent their currencies from appreciating any further against the euro.  In both cases, intervention in the currency market through the purchasing of euros with both Danish kroner and Swiss francs had failed to stem the flow of euros into both nations.  Why would both Denmark and Switzerland be so concerned about the strength of their currencies, particularly against the euro?  In both nations, their major trading partner is Europe.  When their exports to Europe become too expensive because of the high value of both the kroner and the franc, their economies will suffer.  On top of that, it will be cheaper for Danes and Swiss consumers to import/buy goods from Europe since the euro is relatively cheap, again, negatively impacting the local economy. 

Now, let's look a bit more deeply at the entire concept of negative interest rates.  An interesting paper on negative interest rates was published by the Federal Reserve Bank of New York back in August 2012.  The paper entitled "If Interest Rates Go Negative....Or, Be Careful What You Wish For" by Kenneth Gorbade and Jamie McAndrews provides us with an interesting examination of what happens when interest rates go sub-zero.  Here is a summary.

To set the stage, we first have to look at banking system reserves and excess reserves that are held by the Federal Reserve.  Right now, the Federal Reserve actually pays the banking system 0.25 percent interest to keep excess reserves on deposit with the Fed.  This experimental monetary policy came to life in 2008 as part of the Emergency Economic Stabilization Act of 2008, the Act that famously bailed out the entire U.S. financial system.  The logic behind this decision is quoted here:

"The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability."

The Fed also believes that it can change the interest rate on excess reserves, an action that will provide it with an important "exit strategy tool" when it begins to remove monetary stimulus."

In the year prior to the Great Contraction (i.e. 2007), required banking system reserves averaged $43 billion while excess reserves averaged a measly $1.9 billion.  This relationship had been pretty consistent over the previous fifty years, however, in general, excess reserves were less than 10 percent of total reserve holdings because depository institutions had an incentive to minimize excess reserves since they earned no interest.  As I noted above, all of that changed in September 2008 when the Fed began to pay interest on excess reserves.  These actions by the Fed caused this to happen:

So, why did the banking system send trillions of dollars to be stored in the Fed's vaults, figuratively speaking, of course.  Because, there is NO risk to having the Fed hold your money and, as an added bonus, the banking system makes 25 basis points in income for its trouble along with avoiding lending the money to those pesky consumers who might default on their loans!    

Let's go back to negative interest rates and the paper in question.   The authors of the paper suggest that, if economic conditions required, the Fed could push interest rates in the broader economy into negative territory by charging interest on excess bank reserves.  By taking this step, which is similar to that taken by Switzerland and Denmark, other interest rates would follow in lockstep.

Now, let's look at the impact of negative impact on the economy.  The authors suggest that negative interest rates greater than 0.50 percent would have a significant impact on the financial system.  For instance, while small retail investors may prefer to hold at least some cash rather than deposit money in a bank account to avoid a negative interest rate charge, wealthy individuals, corporations and governments would find this to be logistically impossible since storing millions or billions of dollars worth of currency would be both costly and provide a significant security risk.

Here are some of the authors' projections about might occur in a negative interest rate environment:

1.) As the number of individuals who wish to hold physical cash grows, the United States Treasury Department will be forced to print more currency.  

2.) In the case of larger amounts, financial innovations would likely occur with the formation of special purpose bank accounts that offer conventional checking services for a fee by pledge to hold no assets but cash.

3.) Interest avoidance strategies would emerge.  For instance, a taxpayer could make large excess payments on their individual income tax and property tax filings.  In the case of federal taxes, taxpayers would allow the IRS to hold their money and refund the excess the following April.  As well, holders of credit cards could make a large advance payment and then run down the balance with subsequent purchases.

4.) As interest rates become more negative, consumers and businesses will have increasing incentive to make payments quickly and receive payments slowly, changes that would also likely spawn financial innovation.  This is in sharp contrast to the reality that most of us have grown up with, particularly in the late-1970s when spiralling short-term interest rates created a situation where consumers and businesses wanted to delay making payments for as long as possible and collect payments as quickly as possible. 

The existence of negative interest rates will also impact the accounting profession.  It is interesting to observe that the International Financial Reporting Standards Foundation (IFRS), a non-profit account organization that develops and promotes financial reporting standards, has already recognized that negative interest rates are having a significant impact in the "...presentation of income and expenses in the statement of comprehensive income.".  Interest resulting from a negative effective interest rate on a financial asset does not meet the definition of interest revenue because it reflects an outflow rather than an inflow of economic benefits.  It is also not an interest expense because it arises on a financial asset rather than a financial liability.  Obviously, the change to a negative interest rate environment will make a lot of accountants and tax lawyers very, very wealthy as their clients scramble to understand their new reality.

While the U.S. economy is showing some signs of strength, it is also definitely not as healthy as it could be, particularly when we look at long-term unemployed, declining workforce participation rate, growing debt levels and overly elevated real estate valuations in some markets (particularly parts of California) among others.  With interest rates at the zero bound, the Fed is running short of ammunition to stimulate the economy if should happen to slow down again, a scenario that is not all that unlikely given the slowing in both Europe and the Far East.  As well, if the United States dollar continues to appreciate as investors flee to the "currency of last resort" in growing numbers, the Fed may be forced to act to push the value of the dollar down as is the case in Denmark and Switzerland.  

As it looks now, the Fed faces the option of further bloating its already morbidly obese balance sheet or pushing interest rates into negative territory if it is backed into a policy corner.  Unfortunately, as was true in the case of both quantitative easing and interest rate twisting, the real impact of the negative interest rate experiment is unquantifiable, however, there is one thing that we can say for certain about negative interest rates; never, but never say never.

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