President Donald Trump’s call for the Fed to slash interest rates to zero or “less”, so that the Treasury can lock-in low borrowing costs for the very long term, sounds appealing in a sustained low inflation environment. But the evidence from other economies is that negative rates have provided little benefit, while extending the duration of the Federal debt could counter the effects of any renewed quantitative easing.
- President Donald Trump’s call for the Fed to slash interest rates to zero or “less”, so that the Treasury can lock-in low borrowing costs for the very long term, sounds appealing in a sustained low inflation environment. But the evidence from other economies is that negative rates have provided little benefit, while extending the duration of the Federal debt could counter the effects of any renewed quantitative easing.
- Earlier today, Trump tweeted that “The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt. INTEREST COST COULD BE BROUGHT WAY DOWN, while at the same time substantially lengthening the term. We have the great currency, power, and balance sheet…..” We’re a little more sanguine than many commentators about Trump’s repeated explicit criticism of the Federal Reserve and its Chair Jerome Powell. At this stage, it’s largely just background noise and a transparent attempt to blame the Fed for any economic slowdown that would otherwise be attributed to Trump’s trade war with China. Up to now, the Fed has staunchly resisted any political pressure to change its policy. But this is the first time that Trump has called for a negative interest rate.
- The first thing to note is that, although a few other central banks have adopted negative rates, including the ECB, there is a question mark over whether such a policy would even be legal in the US. According to the 2006 law that gives the Fed the power to pay interest on reserves, banks “may receive earnings to be paid by the Federal Reserve”, but that doesn’t necessarily mean the Fed has the power to charge banks a fee on those reserves. Nevertheless, when asked in 2016 about the possibility of implementing a negative policy rate, then-Fed Chair Janet Yellen said “I’m not aware of anything that would prevent us from doing it”.
- As we discussed in our recent Global Economics Focus (here), the effects of negative rates in Denmark, the euro-zone, Sweden, Switzerland and Japan have been mixed. Bond yields have fallen into negative territory, even at the long end of the curve, but commercial banks have been reluctant to cut their deposit rates below zero which, along with the flat yield curve, has resulted in a squeeze on their profits instead.
- The reluctance of banks to charge ordinary households a fee on their savings is understandable given the political storm it could ignite. As a highly-leveraged property developer, Trump is thinking about negative rates from the perspective of a borrower, but the Fed’s lukewarm appetite for negative rates is partly because officials know that it could cause outrage among savers and drag the central bank into a political maelstrom.
- Furthermore, there are a couple of quirks in the US financial system that could make implementing a negative policy rate more difficult. First, just as the Fed only has the power to pay interest on reserves to certain institutions, it presumably wouldn’t be able to charge a fee to all institutions that hold reserves, which would create an arbitrage opportunity. If Fannie Mae, Freddie Mac and the Federal Home Loan Banks were exempt from being charged interest (just as they are exempt from being paid it) then they could borrow excess reserves from banks for a minimal fee. Second, although money market mutual funds are no longer in danger of “breaking the buck”, if Treasury yields and rates fall into negative territory, those funds could experience large-scale outflows, as investors deposited their funds in banks. That would cause at least a temporary disruption to short-term funding for businesses, banks and possibly even the Treasury too.
- All of this helps to explain why Fed officials have shown much more enthusiasm for forward guidance – including changing the operating framework to incorporate a price level or average inflation target – and a return to quantitative easing.
- But in any future economic downturn, the efficacy of quantitative easing could be reduced if the Treasury was simultaneously trying to extend the average duration of its debt – perhaps by issuing a 100-year bond. “Lengthening the term” of the Federal debt would essentially be an Operation Anti-Twist, with the Treasury adding to the duration in the market as the Fed would be trying to reduce it by focusing its purchases on long-term debt.
Paul Ashworth, Chief US Economist, +1 416 874 0520, firstname.lastname@example.org