Is the Fed Invincible Enough to Take Interest Rates Negative?

* The invincibility of the Fed: Do you think the Fed can act in such a way as to jump-start the economy if it starts to sag during the second half of this year, if needed? Obama repeatedly says what a great job Bernanke and his merry band of money printers are doing, and how they helped save us from a certain depression in 2009. That was also his stated rational for nominating Bernanke for a second term last year. How much of this ego inflating praise do you think Bernanke believes? Is theFederal Reserve omnipotent and able to “bend steel with their bare hands”, can they “change the course of mighty rivers”, or are they “able to leap tall buildings with a single bound”? Look, up in the sky! Is it a bird, is it a plane? No, it’s Helicopter Ben dropping bags of money onto the balance sheets of his favorite, government run banks.


If only it was so easy. After purchasing $1.7 trillion of mortgage and government securities in 2009, to replace the run-off from the emergency lending programs of 2008, and holding interest rates near zero since then, the Fed is running out of maneuvering room. There are a few more tricks up their sleeve which the Fed can implement. They can keep printing money by buying securities. This would force interest rates on these securities to even lower levels. Unless of course the holders of these securities are happy to sell them, because they become concerned that the end game will be an increase in inflation. The Fed can also stop paying interest on the bank reserves held at the Fed, which totalled almost $600 billion at the end of March. This would cause these banks to try to collect what ever modest return (next to zero) they can get. This would push interest rates on short term T-Bills, already under 2/10th of 1 percent, to zero, or even negative. What if the Fed in fact, charged banks to keep money with them, effectively creating a negative interest rate on deposits. This would force these banks to lend the money out at a negative interest rate, so long as that negative rate was not as negative as the rate the Fed charges for keeping excess reserves with them. This would clearly force the banks to get the money off of the Fed’s balance sheet, and into something else, which supposedly would be good for the economy because the rate banks will charge on loans would drop, and presumably, this would encourage folks to borrow. How low can rates go? I do not expect the Bernanke to suggest anything as bazaar as negative interest rates today. But suppose the Fed charged banks 1% to keep money on hand with them, in effect, a negative 1% rate. It would result in a game of hot potato, with banks then happy to lend their money at -0.8%, instead of paying 1% to the Fed. In turn, banks might actually start to charge people to keep money on hand with them. If it ever got to that, then I would suspect that lots of people would be taking money out of the bank and stick their bank notes in a safety deposit box. How stupid would that be? What would you do if your banks and brokerage accounts charged you to keep cash on hand with them?


One of the things which would result from such a policy is that people would start spending the cash they had, since that might be a better prospect than watching their money earn a negative interest rate. Or they might invest in longer term bonds, or invest in stocks, resources or precious metals. In effect, it would force people with cash to do something with the cash, which presumably would be good for the economy. To that I would say that if the current low level of rates on all things ranging from short term money market instruments to longer term bonds is not encouraging addition turnover in the nation’s banking system, then I really do not think that there will be any real consequence from the Fed trying to step on the accelerator.


This topic comes to light as Ben Bernanke will be testifying to Congress today in his semi-annual Humphrey Hawkins testimony. After 16 months of a presumed recovery, the economy is not doing much better than it was 16 months ago, and still far worse than anything seen before the recession/depression started. $800 billion of stimulus on top of an already large amount of deficit spending, and in addition to a zero interest rate policy by the Fed, and the influx of $1.7 trillion of new (non-emergency) lending by the Fed. As I have tried to state in the past, all the Kings Horse and all the Kings Men, are not going to put this deflationary scenario back together again. Although they are sure trying hard.


How much more heroic can the Fed and the administration be? We know that they do not want to preside over what will be called a depression, and will try real hard to avoid it. Something as stupid as a negative rate of interest on cash should not be dismissed. What does this mean for the prospects for long term interest rates? If I step back and look at the last 30 years, it is apparent to me that we are not out of the secular, declining rate environment. Since the 10 year rate was as low as 2.05% in December of 2008, hedge funds and traders have been actively betting that rates will never be so low, and the only place for them to go to is higher. Having been in this business since 1981, when interest rates on 20 year treasury bonds hit 15.75%, I have seen interest rates steadily come down. Each time rates pierced a new low and established a new lower trading range, the mentality was that rates would never go lower. Of course, rates continued to go lower, as the attached graph indicates. The floor on 10 year treasury rates was 10% in the early 1980s, then 7.0% in the late 1980s, 5.5% in the early 1990s and 3.2% in the early 2000s, and 2.0% currently. I have learned never to say never towards even lower interest rates, and even as I contemplate how high interest rates might rise if the US’s credit rating was called into question by our creditors, the Fed can very easily push short term interest rates to negative territory, and push long term rates lower though the purchase of debt via their money printing operations. 


It would be surreal if the Fed were to push the envelope another notch towards lower interest rates. Although I must admit that I found it surreal, when the Fed pushed interest rates to zero in the first place, and equally surreal when announced their purchase of $1.7 trillion of securities. Until the 10 year rate goes above 4.5%, and take out the upside of the channel in the attached graph, I would not rule out a further drop in rates. When rates were in the high 3s earlier this year, I argued for a rally to the 2.8 to 3.2% range, which we have now achieved. From here on out, I am neutral on US rates, for the record.


Back to the Fed: Let’s just say the Fed chose to monetize $500 billion of the government’s deficit a year. Since we are experience a very low (1%) inflation rate, the Fed is not likely to be worried about near term inflation, if the economy showed signs of taking another leg lower. And this is exactly what the economy is doing, with many metrics, such as housing, jobs, consumer confidence studies, and the bell-weather of international trade, the Baltic Dry index, are taking another swing at their worst days in 2009. In fact, the Fed’s statement last month, following their meeting allowed for the possibility that the Fed might have to fight the forces of deflation and a slowing economy. And this is likely what Bernanke will say in his Congressional testimony today. 


So what will a half a trillion of cash in the banking system do for us each year? If inflation stayed low, then it would hopefully continue to keep interest rates at low levels which would allow the economy more time to right itself. And the banks which borrow at zero or negative rates, would continue to enjoy a good spread between their borrowing costs and the rate they lend at. When would inflation become a concern? Maybe never, but I know that would just be wishful thinking. In the meantime, next few years, it is likely that deflation will reign and the economy will falter, as it is doing, which will give the Fed the cover to keep printing money, and to attempt to keep interest rates low. 


In short, I conclude that there is plenty of things the Fed can do, but I doubt how useful or consequential they will be, except to extend the rally in the bond market.


* Fin-Reg – one unintended consequence – It is just coming to light that ratings agencies might be liable for investor losses if the ratings they issue on new securities turns out to be bad. According to the WSJ, “the new law would make the ratings firms liable for the quality of their ratings decisions, effective immediately.” On the one hand, they should be accountable, and on the other hand, there is no way they have enough capital to make good on investors losses if they mess up, because invariably, they will make bad calls from time to time. In fact, based on what happened in the rated MBS markets, there is no way some of their ratings are defendable.


Accordingly, the ratings agencies are not allowing their ratings to be used in prospectuses and the like, until they are able to get resolution on what the new Fin-Reg bill means to them. In short, if the bill holds up as the current reading of it implies, then this could be the death of the ratings process.


* In response to the readers comment, which I included in yesterday’s blog, a reader writes in with the following:


Rick, you responded to most of the reader’s comments but I wanted to add this:


“Your reader wrote: ‘Children who have not accomplished any more than being born to well to do families have added nothing and should not be allowed to inherit great gobs of our national wealth. Recycle this money.’


Part of the reason their well to do families are so well to do is the expectation of being able to provide it to their children. They would not produce as much wealth for themselves (and through the benefit of their work, wealth for the entire country) if they would not be able to pass any along. They would simply retire and do what makes them happy (perhaps training their children to create their own wealth would move up on the agenda, which would have some positive effect, but it could just as easily be yacht racing or gambling). I know you already know that, but it is just silly for anyone to make that argument these days. It isn’t as if people would just continue to be productive beyond their own capacity to spend if they don’t benefit from it somehow, charitable bequests being one of those benefits. Ego can keep you driving for a while, but if you thought the government was going to confiscate everything you had attained upon your death, you’re likely to just waste it or simply stop trying to make it.” (end of readers comment)


Thanks for passing that on… I thought that part of the reader’s comment was ridiculous when I read it, but somehow ignored it.