On Wednesday, Federal Reserve Chair Jerome Powell said the Fed is still not considering cutting interest rates into negative territory.
Goldman Sachs co-head of global foreign exchange, rates and emerging markets strategy Zach Pandl said Thursday that the Fed is just one more COVID-19 outbreak wave away from cutting rates below zero.
What Are Negative Rates?
The primary interest rate the Federal Reserve manages is the fed funds rate. The fed funds rate is the interest rate banks and other institutions charge to lend money to each other, typically on an overnight basis. Banks also indirectly base savings rates, mortgage rates and credit card rates on the fed funds rate as well.
When interest rates drop below zero, lenders are actually forced to pay borrowers to take their money. On the surface, the idea is counterintuitive. Yet several central banks around the world have tested the waters of negative interest rates as a way of providing artificial economic stimulus.
How Are Banks Impacted?
Banks are unable to drop interest rates below zero on the average consumer deposit accounts or they risk customers withdrawing and hoarding their cash. Banks in other parts of the world have successfully been able to lower interest rates on large corporate accounts below zero because it’s nearly impossible for tax-compliant large businesses to operate without deposit accounts.
How Will Banks Profit?
Retail banks make profit on the difference between the interest rates they charge on loans and the rates they pay on deposits. This spread is known as a bank’s net interest margin, or NIM. In general, the lower interest rates go, the more NIM is compressed and the less wiggle room banks have in maximizing profits.
When Japan dropped interest rates below zero, bank NIMs predictably dropped, applying pressure on bank earnings. In a negative rate environment, banks will be forced to try to offset these pressures by increasing profits in areas outside of deposits, such as ramping up fee revenue or increasing investment banking activities.
Negative Rate Winners, Losers
The most obvious winners from negative interest rates are people and companies with large debt loads. Falling interest rates decrease the cost of borrowing money. In the theoretical extreme, some companies could even be paid to borrow money if interest rates are below zero.
The biggest losers from negative interest rates are people with savings and companies with large cash balances. If interest rates drop below zero, companies will essentially be penalized for holding cash. Instead, many companies will be forced to invest that cash, which is the theoretical justification for negative rates in the first place. By forcing companies to invest and spend money, negative rates in theory will help drive economic growth.
That same stimulus also benefits stock investors. In addition to forcing companies to invest cash, negative interest rates also make low-risk sources of investment income, such as savings accounts, CDs and Treasury bonds, unappealing. The lower interest rates fall, the fewer viable options investors have and the more money flows into stocks, driving share prices higher.
What Else Can The Fed Do To Stimulate?
The Federal Reserve essentially cut the fed fund rate to zero back in March, but that doesn’t mean that it has no other options for stimulating the economy. The Fed has a history of quantitative easing, buying large quantities of government and mortgage bonds to provide liquidity to the economy. In March, the Fed announced a new unlimited QE program to help combat the economic slowdown.
The Fed also initiated a program for buying corporate bonds for the first time and even set aside up to $500 billion to buy bonds from state and large local governments as well.
There are other more extreme measures that the Fed could potentially take in the future in addition to dropping interest rates below zero. The Federal Reserve could actually print money and distribute it directly to Americans. This policy is known as “helicopter dropping.”
The Fed could also choose to go beyond supporting corporations by buying bonds and also begin buying shares of stock. That idea may seem extreme, but Japan’s central bank has already been buying stocks.
With even President Donald Trump talking up the potential economic benefits of negative interest rates, American investors should be financially prepared for the possibility. If cash becomes the enemy and the the Fed forces companies to spend it all, one of the best places to invest may simply be a low-cost S&P 500 index fund, such as the VANGUARD IX FUN/S&P 500 ETF SHS NEW (NYSE: VOO) or the SPDR S&P 500 ETF Trust (NYSE: SPY).