The path out of the COVID-19 pandemic is unfolding in the same patchwork way that business...
Coronavirus Recession Renews Debate Over Negative Interest Rates
As the coronavirus pandemic has sent the US economy into a tailspin worse than anything seen since the Great Depression, the Federal Reserve has turned to drastic and unprecedented measures to control the damage and set up the economy for a strong recovery. After announcing emergency rate cuts in March, the Fed has leveraged extensive emergency initiatives like buying municipal bonds, lending money to small and mid-size businesses unable to qualify for loans from the Small Business Administration, and buying corporate bond ETFs to effectively pump $2.3 trillion into the economy.
One controversial monetary policy the Fed has not yet turned to, however, is negative interest rates. Implementing negative interest rates, as the term suggests, means that interest rates would drop below zero. In such a scenario, banks would pay interest simply for depositing their spare funds with the central bank, as they are required to do. The advantage of this, theoretically, is that it would encourage consumers and banks to take more risks of borrowing and spending money, thereby boosting the economy.
The downside to such a policy is that it discourages saving by making it costly to hold money in a bank account, potentially hampering the economy in the long run and reducing the amount of money banks have to lend in the first place.
Negative interest rates have been used by economies in Europe and Japan since the Great Recession, but have not yet been implemented in the U.S. Their effectiveness is a subject of debate among economists.
Fed Chairman still wary of negative interest rates
At the moment it appears unlikely negative interest rates will be implemented in the U.S. because Federal Chairman Jerome Powell has ruled them out. Recently he said he doesn’t believe it would be an “appropriate tool” in the United States.
“I would say the evidence on whether it actually works is mixed,” Powell said last month in a webcast with Alan Blinder, a Princeton University economics professor and former Fed vice chair. “There are clearly some negative side effects, as there sometimes are with these things, and it’s just not clear to my colleagues and to me on the Federal Open Market Committee that this is a tool that would be appropriate to deploy here in the United States.”
Instead, the Fed under Powell has kept interest rates close to zero and says it intends to keep them there until the economy recovers, choosing instead to expand its asset purchasing program to stimulate the economy.
A Federal Reserve economist makes his case
Earlier this month St. Louis Federal Reserve Economist Yi Wen released a paper in which he argued that negative interest rates would help ensure that the U.S. economy sees a sharp and broad “V-shaped” recovery. Wen reached this conclusion by comparing federal responses to the Great Depression and the 2008 financial crisis. He found that more aggressive approaches like the New Deal implemented by President Franklin Roosevelt during the Great Depression helped generate a quick and broad recovery, while the use of mostly monetary responses from the Fed after the Great Recession led to a more protracted, L-shaped recovery that failed to reach GDP potential.
“I found that a combination of aggressive fiscal and monetary policies is necessary for the U.S. to achieve a V-shaped recovery in the level of real GDP,” Wen wrote. “Aggressive policy means that the U.S. will need to consider negative interest rates and aggressive government spending, such as spending on infrastructure.”
He went on to argue that such policies will be needed over an extended period of time, not merely as an emergency measure during the worst of the current crisis.
“These policies also need to continue even when the crisis is about to end to provide a further boost, leading to a more robust recovery,” he wrote. Wen called for a two-pronged approach beyond the capabilities of the Fed itself of both negative rates and more federal government spending.
Second wave of coronavirus could change Powell’s mind
“If the economy has another big setback… where you have a second wave of infections and it would really take the recovery off course, then I do think that that opens up a possibility of a range of additional actions,” Zach Pandl, Goldman Sachs’ co-head of global foreign exchange, rates and emerging markets strategy, told CNBC’s “Street Signs Asia” last month.
While Pandl admitted that he didn’t think negative interest rates would be particularly helpful, he said policymakers will be tempted to try new things if the economy struggles for an extended period of time.
“So in that scenario, perhaps they can consider it, otherwise I think it’s pretty low probability at this point,” he said.
Experts at ING reached a similar conclusion, noting that “the Fed has been very careful not to completely rule out negative interest rates and the Fed funds futures market thinks that the (Federal Open Market Committee)… could eventually soften its stance. The catalyst could be a second wave of Covid-19 and renewed lockdowns with associated economic and financial market distress.”
They, too, however, concluded that even in the case of a second wave of coronavirus infections, negative interest rates would not be any more helpful than expanding the tools the Fed is already using, especially given the costs involved.
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