I hate to add to the growing number of articles out there on negative interest rates (which means you pay, not earn interest on your money). I’m not one usually to delve into popular topics broadly covered elsewhere, but interest rate policy is in my wheelhouse and believe I can add perspective to the topic, so here goes.
The concept of negative interest rates moved from academic theory to practice in various parts of the globe in recent years. Now the debate has heated up (and will continue for some time) in the US. We have the President calling for them (Presidents always want lower rates), but the Fed chairman has been busy pushing back against the prospects of rate cuts in the US. Fed futures market – where investors can bet on where rates will be in the future – recently traded at prices that indicate the next move move to be a cut from zero, not a hike.
A quick aside, I find our fascination with zero to be a little peculiar. After all, the difference between 1 and 0 is exactly the same as the difference between 0 and -1. So, on one hand I think it behooves us to remove this artificial and arbitrary focus on ‘0’. On the other hand, I get the real-world practical limitations of having to pay someone to store your money for you*. As an individual, you have the option of simply storing it yourself in cold, hard bills in the privacy of your home.
However, it is quite impractical for corporations and institutions to hold their cash in actual bills versus bank deposits to avoid a negative interest rate. Using data from the Federal Reserve and Statista, institutions hold roughly 30% of the nation’s M2 money stock. But we can extend the storage impracticality to the American wealthy whom hold the lion’s share of cash that is in the hands of private individuals (which has had sad and devastating recent impacts during this crisis as so many have been unable to accumulate even just a minor reserve). But for those that do have large savings, it’s one thing to store a few hundred or thousand dollars under your mattress, in your freezer or in a safe (all of which are exposed to risks like fire and theft), and quite another when you are talking a few million or billion.
This isn’t a case for negative interest rates just yet. Rather, it’s about crafting a more useful way to think about them. A more useful framework, that, given more time and widespread understanding may make them more of a reality here in the US. The main component necessary to frame the role of negative rates is to shift the focus away from the stated or “nominal” interest rate and towards the real rate, which is adjusted for inflation. Unquestionably, the real rate is the primary focus of the Fed.
The chart demonstrates how persistently the Fed pursued a negative real interest rate policy until late 2018/2019. This shift naturally brought about economic slowdown concerns, long before we ever heard of novel coronavirus (recall the inverted yield curve last year?). In effort to help stem this crisis, the Fed abruptly shifted back to a negative real rate. But here is their current challenge: current price trends are deflationary. Using the current PCE inflation rate of 1.7% (notably as of March 31st), the Fed has pushed rates back into the negative real territory they occupied through much of the expansion. But that doesn’t tell the complete picture.
Using the core PCE inflation rate means using stale, backward looking data. I find it helpful to incorporate the market’s prevailing forward view on interest rates as well, specifically using 10-year breakeven spreads (a couple of prior posts dive into the explanation of this difference so I won’t repeat here). This is a crucial view for periods like this one where the market quickly develops a view of the future that looks different than the current view. For the next 10 years, current treasury markets are baking in roughly a 1% inflation rate. I also wrote about this in March and avoiding panic reactions based on the extrapolation recent trends (which our brains are wired to do). The current 1% forecasted inflation rate incorporates this period in the short run that is destined to be a pretty strong deflationary shock and then presumably a period of modest price recovery. When we sub in these 10-year expectations as a proxy for calculating real rates in the chart below (orange), we can see expected real rates are still firmly above the levels seen during most of the 2010’s. We would need either a) a much stronger pickup in inflation expectations (which will likely take some time) or b) a cut of interest rates firmly into negative territory.
Now, given the Chairman’s continued push back to negative real rates as recently as this week, a cut of overnight rates into negative territory will be a long time coming. It would likely take a sustained period of such stubborn inflation expectations. Long before a change in rates, we would very likely see a thawing in not only the Chair, but also other FOMC members’ language as well. Now here is the kicker, before that, as we have seen time and time again the market itself will likely beat them to the punch and be pricing in such a scenario. These implications would continue to ripple loudly through the bond markets.
*Technical issues for financial institutions also arise but well beyond the scope of this article.
