What would force the Fed to go negative?

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Federal Open Market Committee members have adamantly opposed negative interest rates and said lowering the Fed funds rate target into negative territory would be a last resort.

While they say “every tool is on the table,” they consider other options better and “more powerful,” since negative rates don't have a track record.

And while most analysts agree the Fed would use this tactic only when no other choices are left, here's what they say would need to happen for the Fed to reconsider, or even be forced to adopt negative rates.

Deflation, according to Jeffrey Cleveland, chief economist at Payden & Rygel, could be the impetus. “As of April we saw back-to-back drops in core CPI (the second time that’s happened since 1957), so we are seeing disinflationary pressure,” Cleveland said. “But core CPI is still year-over-year less than 1%.”

Jeffrey Cleveland
Deflationary pressures could push the FOMC to reconsider negative rates, according to Jeffrey Cleveland, chief economist at Payden & Rygel.

The dollar and living space will be the keys to deflation. The dollar must "remain strong or strengthen further, and shelter — the biggest component of inflation, [will have to] start to roll over,” he said. “Watch rents and housing closely.”

If the economy doesn't rebound quickly enough, negative rates are likely, said Zach Abraham, chief investment officer at Bulwark Capital Management. If unemployment were to stay above 12% for an extended period of time it could force the Fed to move.

And Abraham thinks we will get to the point where negative rates will be the only option.

“Unfortunately, we believe that unemployment will be structurally higher following the COVID-19 crisis and believe the Fed will try negative rates,” Abraham said. "If you want to know where the Fed is going, look at the [Bank of Japan] and [the European Central Bank]. The irony is that negative rates have been a disaster wherever they've been implemented, so you'd think the Fed would learn from the mistakes of others.”

In Abraham’s opinion, investors need to plan for extreme monetary policy since it's not going away. And in addition to negative rates, he expects the Fed's "balance sheet [will] continue to explode" and "eventually, you'll see the Fed buy equities. They're buying high-yield debt and fallen angels. They'll buy equities too at some point.”

Besides high unemployment, it could take a large second wave of COVID-19 cases later this year, again threatening the economy, before the Fed would reconsider rates below zero, according to Giles Coghlan, chief currency analyst at HYCM. Before trying negative rates, the Fed would want to put money directly into the hands of consumers and businesses.

“If U.S. unemployment remains high once COVID-19 restrictions are lifted, however, then the Fed may be in a position to 'pull out all the stops' and push rates negative,” Coghlan said. “However, it is very much a last resort. The implementation of negative rates in Japan and Europe have not helped stimulate their economies, which is why the Fed will be reluctant to undertake the same measure. If U.S .rates do become negative, I would expect demand for gold to rise in response.”

Nisha Patel, director of fixed income portfolio management at Parametric Portfolio Associates, said the Fed would first need to exhaust all options and see failures of large-scale purchases and measures like yield curve control. “If those measures have been tried and fail, and the economic rebound is very disappointing, the last resort may then be negative rates,” Patel said. “However, it seems that the Fed is leaning on government to push further fiscal support before looking to exhaust all their options and go to negative rates. And you can’t blame them because if the Fed goes down the path of negative rates, there will be no turning back and no way of assessing whether any positive impact will come from it.”

And negative rates could cause pain at the start. “Since our financial systems and markets are not set up for a negative rate environment, there will surely be significant short-term shock and damage control that the Fed will need to mitigate and prepare for,” she said.

Steven Skancke, chief economic advisor at Keel Point and former White House National Security Council staff member, said it would take turnover on the Fed.

“Not only do negative rates interrupt bank intermediation and discourage bank lending, the $4-plus trillion U.S. money market fund holdings aren’t equipped to handle negative nominal rates on U.S. government securities,” Skancke said. “Based on all the Fed has said and written, there would need to be a new Fed chair and a sufficient number of Federal Reserve Board governors appointed by the president who would be committed to moving to negative interest rates.” Skancke discussed negative interest rates in a recent Bond Buyer podcast.

And while other countries have turned to negative interest rates, Robert R. Johnson, chair and CEO of Economic Index Associates, said, the biggest problem with negative rates is there is no compelling evidence that they work.

“I take Fed officials at their word that they would have to exhaust all other options before invoking negative rates to stimulate economic growth,” Johnson said. “All of the infusions of liquidity, buying ETFs and corporate bonds as well as the fiscal stimulus measures of the Trump administration, show that officials are erring on the side of too much stimulus rather than inaction. These unprecedented programs are intended to provide a financial backstop for U.S. companies.”

Ron Carson, founder and CEO of Carson Group, echoed Johnson’s sentiment. “The economies that have used negative rates continue to struggle for growth,” Carson said. “The Fed will employ additional quantitative easing, use interest rate targeting and communicate forward guidance before it seriously considers using negative rates.”

Since they don't appear to be effective, Gary Zimmerman, CEO of MaxMyInterest, doesn’t anticipate the Fed will resort to negative rates. “Europe’s experience with negative rates during and following the financial crisis suggests that such a policy would be unlikely to be effective,” he said. “Instead, Chairman Powell has stated that at this point, fiscal policy measures would be most appropriate to supplement the monetary measures already taken to support an economic recovery.”

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