Despite a recent uptick in rates, media pundits and investors continue to speculate about the possibility of negative interest rates in the United States.
Let’s take a step back to remember what the Federal Reserve’s primary tool is for carrying out its dual mandate of managing inflation and maximizing employment: Short-term monetary policy. Since Chairman Powell’s “tightening on auto pilot” language sent markets into a tailspin in December 2018, the Fed has loosened monetary policy in an effort to address elevated uncertainty in the global economy. It is important to remember, however, that the Fed’s short-term approach to help stabilize growth for the long term would not be possible in a negative rate environment.
While negative-rate policies do have their merits, such as helping with components of asset valuations and benefiting certain areas of an economy, they ultimately stymie a central bank’s ability to respond in a downturn and could result in ramifications beyond any short-term benefits they may yield. To highlight this point, we examine what’s happening in the euro zone. Despite the European Central Bank’s aggressive use of negative interest rates (Figure 1) and balance-sheet expansion, their economy has simply not generated any meaningful amount of growth or inflation. Rather, the approach has resulted in suppression in its system: Already-high consumer savings rates are trending higher, the profitability of euro zone banks has suffered, and pessimism about the ECB’s ability to manage through another downturn continues to rise.
As of 9/30/19. Source: European Central Bank, Federal Reserve, Eurostat, Bureau of Labor and Statistics and Bloomberg.
Increased Opportunity Costs
With negative rates depressing current and future investment return expectations, Europeans are having to make up the difference with more savings. Their impulse to spend is being overwhelmed by the reduced return on their nest eggs and therefore their ability to have the same income stream in the future. In the United States, savings rates have also trended higher, but from a much lower level and in a positive, albeit relatively low interest rate environment (Figure 2.)
As of 3/31/19. Source: European Central Bank, Federal Reserve, Eurostat, Bureau of Labor and Statistics and Bloomberg.
Bank Profitability Headwinds
While banks in the U.S. certainly have their own headwinds to contend with, euro zone banks have suffered greatly under a negative rate policy. From mid-2014, when Europe’s negative-rate campaign began to accelerate and take hold in the economy, European banks declined nearly 17%, while U.S. banks yielded a cumulative return of nearly 42% over this same time period1. With a rate structure only slightly positive, U.S. banks have handily outperformed their European counterparts during a period of extended Federal Reserve quantitative easing.
The Legacy of QE has yet to be Written
With euro zone interest rates well into negative territory, and the ECB’s balance sheet bloated to around 40% of GDP, many decision makers in and outside of the euro zone – whether they be heads of businesses, investment managers, leaders in infrastructure or even small business owners - are likely growing more nervous about the ECB’s lack of monetary policy options that could be used to respond in a recession. When potential investors see negative interest rates, barely modest economic growth and no inflation, the uncertainty premium begins climbing, harming potential for growth factors. While we recognize that this dynamic is nebulous and could change over time, it nonetheless clouds any confidence one might otherwise have in the economy.
Considering that the Federal Reserve’s dual mandate of inflationary stability and maximizing employment is conducted primarily via monetary policy, taking short-term interest rates negative would exhaust their ability to respond during the next downturn. At current levels, the Fed is in much better shape to combat the next recession. Negative rates would not materially help our current economic trajectory—they would only limit the Fed’s firepower when the next downturn eventually comes.
1 As of 9/30/2019. U.S. Banks as represented by the total return for the SPDR S&P Bank ETF [Ticker KBE] and European Banks as represented by the total return for the iShares STOXX Europe 600 Banks UCITS ETF (DE) [Ticker SX7PEX GY]
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