Negative Interest Rates - Caught Between and Rock and a Hard Place

Throughout the six year history of this blog, I have occasionally posted articles on negative interest rates, a monetary policy that seemed utterly far-fetched back in 2012 when I posted this item.  Even with interest rates showing this declining pattern over a thirty-five year period....

...it seemed highly unlikely that negative interest rates would ever become a reality in the United States until Janet Yellen said this in November 2015:

Here's the key quote:

"If circumstances were to change, suppose economic outlook--which I don't expect--but if it were to deteriorate in a significant way, so that we thought we needed to provide more support to the economy, then, potentially anything including negative interest rates would be on the table."

There's nothing like floating a trial balloon to get an unprecedented monetary policy into the public consciousness, particularly since the economy is on the cusp of a recession despite the Federal Reserve's massive quantitative easing experiment.

Further to the topic of the Federal Reserve following the Europeans and Japanese into negative interest rates, we have this interesting internal Federal Reserve note dated August 5, 2010 which was released to the public on January 29, 2016.  The note examines the impact that reducing the interest rate on excess reserves or IOER would have on short-term money market rates and the overall functioning of the money market itself.  

The note looks at three scenarios:

1.) reducing the IOER rate by one-tenth of one percent.

2.) reducing the IOER rate to zero percent.

3.) setting a negative IOER rate.

What I found fascinating is that the Fed was looking into the possibility and repercussions of implementing a negative interest rate policy as far back as mid-2010.

Let's get a bit of an understanding of the history of the interest rate on excess reserves.  The interest rate on excess reserves (IOER) was one of the new policies implemented by the Federal Reserve during the financial crisis of 2008.  Under the Emergency Economic Stabilization Act of 2008, the Fed was authorized to pay interest on balances in excess of the required balances held by the Fed on behalf of depository institutions.  The original rate was set at 0.25 percent with an effective date of October 1, 2008.  Effective December 17, 2015, this rate was raised to 0.50 percent as part of the Fed's "tightening".   It is this interest rate that the Fed is using to manipulate the economy.

For the purposes of this posting, I am going to ignore the first two interest rate scenarios in the internal note and focus on what the authors of the note said about pushing interest rates on excess reserves into negative territory.  Here's a quote:

"Assessing the possible impact of a negative IOER rate is challenging because there is virtually no domestic or international experience with negative policy rates on which to draw. In Sweden, the Riksbank has, since July 2009, maintained a negative interest rate on excess deposits held overnight by DIs (depository institutions). However, the Riksbank’s daily and weekly market operations are aimed at maintaining overnight rates within a corridor whose lower bound is positive. The deposit facility, for which the rate is negative, is normally little used, and its rate thus has little direct impact on market rates. The Bank of England reportedly considered a negative rate target in its internal deliberations, but never implemented such a policy."

It's pretty obvious that the authors had no frame of reference for negative interest rates at the time that this note was written (2010), however, European central banks have undertaken a negative interest rate policy and Japan recently announced its own foray into uncharted interest rate territory.

Let's go further into the note:

"There are several potentially substantial legal and practical constraints to implementing a negative IOER rate regime, some of which would be binding at any IOER rate below zero, even a rate just slightly below zero. Most notably, it is not at all clear that the Federal Reserve Act permits negative IOER rates, and more staff analysis would be needed to establish the Federal Reserve’s authority in this area. In addition, the Federal Reserve computer systems used to calculate and manage interest on reserves do not currently allow for the possibility of a negative IOER rate, although these systems could be modified over time if needed.  Moreover, if negative IOER rates were to pull Treasury bill yields into negative territory, the Treasury would encounter difficulties because it cannot accept negative rates at its auctions, although presumably it could modify its systems as well.  Finally, as discussed further below, at sufficiently negative IOER rates, DIs (depository institutions) might opt to shift a significant quantity of their reserve balances into currency. Present Federal Reserve inventories of currency, at about $200 billion, would not be adequate to cover large-scale conversion of the nearly $1 trillion in reserve balances to banknotes.  While the operational and legal impediments to a negative IOER rate are likely to be significant, for the remainder of this discussion we will assume that they can be overcome." (my bold)

Here is one of the key impacts of a negative interest rate policy on Main Street:

"At the same time, investors, including bank depositors, could counter attempts by banks to pass along a large negative IOER rate in the form of sharply higher service fees by increasing their own holdings of currency, subject to their own storage costs, which would further reduce reserve balances."

Let's start by looking at what faces the banking system.  Here is a look at the massive size of the banking system excess reserves held at the Federal Reserve:

Right now, depository institutions (i.e. the banking sector) has deposited $2.28 trillion at Federal Reserve banks, currently collecting 0.5 percent interest.  If the Fed changed to a negative interest rate policy, depository institutions would have to pay the Fed to "store" the $2.28 trillion worth of excess reserves.  As the authors of the note suggested, depository institutions might opt to shift their reserve balances into hard currency.  This would put a significant drain on paper currency.  According to the note, the production capability for $100 bills (the largest denomination in production) is no more than $500 billion per year.  This means that it would take the Federal Reserve over four years to print enough $100 bills to cover the banking sector's excess reserves although, surely, the system would create higher denomination bank notes.  

Now, let's look at what faces "Mom and Pop America" in a negative interest rate world.  As shown on this graph, in total, American families have substantial personal savings:

If all savers decided to convert their personal savings to bank notes, it would take the Fed nearly a year and a half to print the $739.3 billion currently held by American savers.  This is where one has to wonder if a policy of currency abolition could be implemented; it would certainly put a quick end to smaller investors and savers converting their savings into cash.

It is becoming increasingly clear that the Federal Reserve has exhausted its current supply of non-conventional monetary policies and is out of ammunition, save for implementing a policy of negative interest rates which will put it firmly between a rock and a hard place.  As you can see from this posting, it is unclear, even to the Fed, whether America's central bank has the legal authority to impose negative interest rates, however, if they do, the logistical complications of implementing such a policy are overwhelming and may well be the first step in a move toward abolishing the use of hard currency, a policy that is already being implemented in parts of Europe.