Federal Reserve chairman Jerome Powell has told everyone from Princeton professor and former Fed vice chair Alan Blinder to Congressional committees to the public at large via press conferences that negative interest rates are not an “appropriate tool” for the United States.
In a recent interview, Powell underscored the point by saying, “the evidence whether it actually works is mixed.”
So is Powell’s stance the Fed’s version of American exceptionalism? That is, it may have had some positive results in Japan and Europe but it won’t work here?
Or, perhaps negative rates will be too disruptive to money markets or detrimental to banks? Or, impossible, of course, for the apolitical Fed chair, they may even have unwanted political consequences in an election year?
In fact, as we demonstrate below, the US Fed has no choice but to push its overnight lending rate below zero, following the example of the Bank of Japan and the European Central Bank, if it wants to stop the aggravating “procyclical” effect of rising real interest rates and their negative impact on markets and the economy.
Negative rates will cause some turbulence in US money markets, where money-market funds are a main source of financing for the commercial paper market including for banks. But that is a technical problem to be managed.
A minority of Federal Reserve economists, for example Yi Wen and Brian Reinbold of the St. Louis Fed, has made the case for negative rates. “Aggressive policy means that the US will need to consider negative interest rates and aggressive government spending, such as spending on infrastructure,” they write.
The market will have to pummel the Fed some more before it reconciles itself to negative rates, but the writing is on the wall.
The next US administration, whether Republican or Democratic-led, should focus fiscal policy on productivity-enhancing investment rather than short-sighted injections to temporary spending.
Until the US economy shifts away from its consumption bubble to a more robust investment-led, productivity-driven growth pattern, it will struggle to get back on its feet.
US equities fell last week as real (inflation-indexed) interest rates rose due to sagging inflation expectations. As a rule, the price of inflation-indexed Treasury securities (TIPS) falls and yields rise when investors expect less inflation.
The Fed has told the market that its overnight rate will stay at zero indefinitely. If the short rate stays zero forever, then long-term bond yields will stay close to zero forever. Bond yields have hit a brick wall at close to 0%.
In a nutshell, bonds have nowhere to go if the overnight rate is fixed long term at 0%, so bonds cease to be a safe haven for investors trying to hedge stock market risks.
The chart below shows the two components of the 10-year Treasury yield, namely the inflation-indexed, or “real”, yield and so-called breakeven inflation – that is, the inflation rate that would equalize returns for holders of inflation-indexed and nominal Treasuries.
The Fed wants inflation of more than 2% per annum, but that won’t be achievable as long as consumers hoard cash rather than buy goods. There’s a simple economic term for such behavior: deflation.
That is, economic actors prefer cash to goods because they think goods will be cheaper in the future. If they think that goods will be more expensive in the future, they buy now rather than later.
Stocks bounced back from the March crash after the federal government and Fed together injected US$6 trillion into the US economy—almost a third of US gross domestic product (GDP)—through emergency support for consumption and purchases of securities ranging from Treasury debt to junk bonds.
The Fed took its overnight interest rate down to zero, and the whole universe of short-term debt instruments now yields zero or just barely above.
The trouble is that bank deposits paying 0% become a good investment if you think that goods will be cheaper in the future. Recent price increases for used cars, computers and other big-ticket items haven’t yet persuaded US consumers to spend rather than save.
The emergency $600 a week unemployment checks provided by the federal government have been cut to $300, and this smaller payment will run out at the end of October unless Congress authorizes more.
Consumption accounts for 70% of US GDP, higher than the industrial country average of 60%. Washington’s failure to agree on further stimulus and the prospect of lower consumption has prompted most forecasters to cut their US economic forecast for the fourth quarter of 2020.
Goldman Sachs, for one, has reduced its growth projection for the quarter to 3% from 6% previously.
When the stock market falls sharply, real Treasury yields typically fall because the market expects that the Fed will cut interest rates in the future to stimulate economic growth. With the Fed’s declared zero boundary, bond yields have nowhere to go. Since the Fed’s drastic easing in March, the 10-year Treasury yield has flat-lined.
In the past month, inflation expectations have fallen due to new surges in Covid-19 infections and other economic stress. If the nominal Treasury yield is fixed by the Fed’s zero-interest rate policy, a fall in the breakeven inflation rate must be matched by a rise in the real yield on inflation-indexed Treasuries. That is just what happened.
Rising real yields from -0.4% to about 0% simply mean that the value of holding money has increased relative to the value of holding goods. That’s the opposite of what is supposed to happen in a stock market correction: Each time the stock market tanked during the past ten years, the Fed stepped in with additional easing.
If the Fed can’t reduce interest rates, then real yields must as the economy weakens and inflation expectations fall.
As indicated in our first chart, rising real yields helped drive the stock market down. The danger, however, is that the stock and bond markets will chase each other down in a descending spiral.
Gold and currencies also fell as US real yields rose, which simply means that the future value of dollar assets is rising relative to competing assets as inflation expectations soften.
The dollar has declined as inflation expectations rose over the past year, seen in the chart below. A reversal of inflation expectations during the past month explains the dollar’s bounce last week.
The normal state of affairs is shown in the chart below. During most of the past five years, real yields and inflation expectations moved in roughly the same direction.
Rising economic activity boosted commodities and other prices, buoying the inflation component of Treasury yields, while market expectations about future Fed policy pushed up real yields in periods of economic improvement and vice versa.
After March 2020, when the Fed nailed its overnight rate to the zero mark, however, inflation expectations and real yields moved in perfect inverse.
The US is not exceptional in this regard. What we have observed during the past five months in US markets has been happening for years in Japan, where consumer prices fell as often as they rose during the past decade. Once the Japanese began to expect deflation, they hoarded cash rather than consumed.
Japan took its overnight rate down to -0.1%. It should have acted more aggressively to reduce rates and force consumers out of cash.
It also increased its sales tax in 2019, a fiscal measure that acted diametrically against the effect of negative short-term rates. Investment meanwhile fell as a percent of Japanese GDP to only 24% during the past five years, compared to around 30% during the 1990s.
The failure of Japanese fiscal policy to support productivity-enhancing investment or to support higher consumption left the Japanese economy stagnant for the past decade.
The US is at risk of repeating this same mistake. It can’t expand federal borrowing, now running at around 18% of GDP, indefinitely. To finance such a deficit, it will require a vast amount of domestic savings to buy Treasury securities.
To entice foreigners to buy Treasury securities, the US has to weaken the US dollar. The rise in real yields during the past couple of weeks pushed the dollar back up.
