Will the Fed Adopt Negative Rates?

While a few foreign central banks have already implemented negative policy rates due to economic turmoil, many in the housing industry are wondering if the U.S. is next.

As Federal Reserve Chair Janet Yellen wrapped up her semiannual monetary policy report testimony in front of the House Financial Services Committee last week, Congress questioned her about possibly implementing a drastic measure in the event that the U.S. economy takes a turn for the worst.

When asked about imposing a negative interest rate, Yellen did not rule it completely out as an option, but said the further investigation would need to be conducted.

“In the spirit of prudent planning, in light of European experience, we will look at, we should look at," Yellen explained. "It isn’t just a question of legal authority, it’s also a question of could the plumbing of the payments system in the United States handle it. Is our institutional structure of our money markets compatible with it? We have not determined that."

Paul Ashworth, Chief U.S. Economist at Capital Economics noted in a report released Tuesday that it is not likely that the Fed will impose a negative interest rate environment. "Even if US economic conditions deteriorated, we suspect that the obstacles to setting the fed funds rate below zero in the US would persuade the Fed to try other unconventional tools first," he said.

Ashworth pointed out a number of obstacles standing in the way of the Fed making this drastic decision:

1. The Federal Reserve Act only gives the Fed the power for interest “to be paid” on reserves held by commercial banks. Whether it can also legally charge interest is another matter that would presumably need to be settled in court.
2. Even if the Fed can legally charge commercial banks for holding reserves under the existing Act, some non-bank institutions that hold reserves but currently don’t qualify to be paid interest would also presumably be exempt from negative rates.
3. The lack of reform of money market mutual funds since the financial crisis is an even more substantive obstacle preventing negative rates in the US.
4. Finally, perhaps the biggest obstacle, particularly in a Presidential election year, is that the Fed would come under unprecedented political pressure if commercial banks began to charge their own retail customers a negative rate on deposits.

"Setting a negative nominal policy rate is not the only option that central banks have to reduce real interest rates," Ashworth explained. "Under the circumstances, the Fed might opt to raise its inflation target instead, either temporarily or permanently. The resulting jump in inflation expectations would push real interest rates further below zero. The Fed could also take measures to reduce long-term interest rates, either by using forward guidance and/or by beginning another round of large-scale asset purchases."