Unprecedented situations require unprecedented actions. That’s why the Fed should fight a rapidly deepening recession by taking interest rates below Zero for the 1st time ever.
When the FOMC holds its regular policy-making meeting next week, all the warning lights will be flashing Red.
The unemployment rate is expected to reach 2X digits by June.
With global demand cratering, the Fed’s preferred measure of inflation will likely fall to 1% or even lower by the end of the year, that is below its target of 2%.
Plus, in the absence of a Covid-19 coronavirus vaccine, the chaos and discomfort will likely persist well into Y 2021.
Any Economics 101 student knows that in such a grim situation, the Fed should cut interest rates to stimulate growth and job creation.
But as Chairman Powell said again last month, the Fed does not plan to do so in the foreseeable future, because a further 1/4% cut would drive the interest rate it pays on banks’ reserve deposits to negative.
The Big Q: Why the fear of negative rates?
10 yrs ago the answer would have been that it was impossible to go below Zero: Banks would simply avoid the charges by withdrawing their reserve deposits and holding the funds in paper currency, which pays Zero interest.
Now economists now recognize that does not happen, because it’s costly to store Billions or Trillions of USDs of paper currency safely.
Several European central banks, as well as the Bank of Japan, have successfully taken interest rates below Zero.
This stimulates consumer demand in these 3 ways: by incentivizing banks to make loans at lower interest rates, to bid up the prices of financial assets, and to charge higher fees for deposits.
Another of the Fed’s concerns about negative rates has to do with financial stability.
Yes, negative interest rates would help lower the unemployment rate from what is likely to be its highest level since WWII. But officials are concerned that they will also weigh on banks’ profitability, pushing down share prices and making the financial system more vulnerable to distress. Meaning this: the Fed is giving up on unemployment reductions to help keep banks and their shareholders safer.
If the Fed really cares about financial stability, it has many tools to ensure it.
For example, it could block large banks from paying dividends, a practice that erodes the capital they need to absorb losses.
None of this stands in the way of a monetary policy focused on the Fed’s congressional mandate of maximizing employment and keeping inflation near target.
With that, the Fed has no good argument against going sub-Zero with interest rates.
This ultra-high unemployment and potentially rapid disinflation should terrify them and they are powerful arguments in favor.
Next week, the FOMC should take interest rates at least 1/4% below Zero.
Have a healthy weekend. Keep the Faith!