By Kim Khan and Geoffrey Smith
Investing.com – The prospect of negative interest rates in the U.S. was once unthinkable but the coronavirus pandemic has changed that. While the head of the Federal Reserve ruled it out this week, the unprecedented economic fallout from the pandemic has forced markets to consider the potential ramifications of such a dramatic policy shift.
Kim Khan argues that pressure from President Donald Trump, who has long criticized his central bank head for keeping interest rates higher than he would like them to be and the mounting economic impact of the pandemic over time mean that negative rates could remain on the table for some time to come.
Geoffrey Smith counters that sub-zero rates simply don’t work as a policy tool to promote growth and argues that a fiscal, rather than a monetary response would be more effective.
The Case for Negative Rates
Fed Chairman Jerome Powell poured cold water on the idea of using negative interest rates this week. In days gone by, that would’ve been that.
The president would’ve said he respects the view of the Fed chair and the independence of the central bank. Even if the president liked the idea of negative rates, such advice would’ve been delivered in private.
Those days are gone.
Even facing a united front from the FOMC, President Trump has a way of getting what he wants. And this has been high on his list for a while.
In the election year, Trump could tout negative rates as a signature achievement, solely his idea as it’s never been done by the Fed before. He could boast about how much free money global lenders are putting in U.S. coffers (and trot out anecdotes of men who have never cried before sobbing over 10 basis points).
None of this has to be economically feasible and none of it has to be true.
Take the U.S.-China trade war.
Trump has consistently claimed that China is paying millions of dollars in tariffs when it’s U.S. importers and consumers that bear the brunt. He told Fox Business this week that if the U.S. stopped trade with China completely the U.S would “save $500 billion,” which isn’t how trade deficits work.
If the Fed drew a line in the sand it would take the leadership of Chairman Jerome Powell to get Trump to back down.
As accomplished as Powell is, and as much as he’s stressed that politics don’t come into play in the Fed’s decision-making, he doesn’t have a great track record in rebuffing the president. He already started cutting rates before the pandemic amid Trump’s griping and desire for further Wall Street gains.
Trump warmed up to Powell following the Fed’s huge coronavirus response, but if the third quarter approaches and things still look dire, Powell could be relegated to “bonehead” status again.
Would you bet on Trump or Powell in that faceoff? It seems anyone who can get Larry Kudlow to renounce free trade could change anybody’s compass.
Finally, even if the president backs off completely the Fed may find itself in a corner with little else it can deploy.
Powell has been pushing for Congress to come through with more stimulus measures, something Minneapolis Fed President Neel Kashkari reiterated Thursday, calling for “money in the pockets of people”.
But a fourth stimulus package looks much more tricky as cooperation in Congress becomes rarer.
If a second wave of Covid-19 comes, the FOMC could be forced to try a further fed funds cut.
A second wave of infections could lead the Fed to “try new things,” including negative rates, Zach Pandl, Goldman Sachs’ co-head of global foreign exchange, rates and emerging markets strategy told CNBC this week.
The Case against Negative Rates
The case against negative interest rates is simple: they don’t work. They haven’t restored strong growth to the euro area, Switzerland, Scandinavia and Japan. Why on earth should the result by any different in the U.S.?
Their proponents, the European Central Bank’s Mario Draghi at the fore, may argue that without them, things would have been a lot worse, but having to argue through counterfactuals already implies that the actual consequences of your policy don’t stand up in their own right.
Powell said on Wednesday that the evidence of their success was “very mixed”, which is about as damning a comment as one central banker will ever pass on another. Tellingly, he said to the Peterson Institute’s Adam Posen, the Fed’s top officials had been unanimous in their rejection of the tool when they assessed a year-long review of the possibility last year.
It should be clear by now that shaving another 25 basis points off the cost of Joe Average’s mortgage or car loan is going to be of less than zero use if Joe – like a quarter of the workforce – has lost his job. Nothing can stop those loans going bad except Joe getting a paycheck again. In the meantime he needs someone to stop his creditors foreclosing on him and to put enough cash in his pocket to feed his family and persuade him not to start a deflationary spiral by selling what assets he has at firesale prices. Clearly these are interventions for an elected authority rather than an unaccountable central bank. In other words, the required fix is fiscal, not monetary.
But not only are sub-zero rates the wrong tool, they’re a tool with powerful and negative side-effects. They destroy bank profitability, making them less able and willing to lend (the European Stoxx Banks index obligingly posted a new all-time low on Thursday, as if to make the point). And while falling bank profits are not everybody’s idea of a nightmare, it is vital that the economic crisis does not also become a financial one.
Finally, negative rates put a tax on savers just at a moment when hiking taxes should be the last thing on anybody’s mind. And in as much as they allow the government to be paid to borrow, negative rates represent a transfer of income from individuals to the federal government. President Trump called negative rates a “gift” earlier this week. But gifts have to be given by someone. That someone is the American saver. How does that make things better right now?