Federal Reserve Asserts Negative Rate Authority

June 22, 2016Monetary Policyby EW News Desk Team

0

Negative interest rates may be coming to America.  A reality in Japan for years and a growing trend throughout Europe, negative interest rates on government bonds have wreaked havoc on financial markets and standard economic models of bond prices and monetary theory.

Negative interest rate policies, or NIRP, are intentional moves by Central Bankers to cause buyers of bonds to actually pay debtors for the privilege of lending them money.

Popular, although increasingly controversial in the European Union, NIRP has been used as one method of encouraging banks to lend to businesses and individuals, as holding bonds would cost banks money. A growing number of analysts warn, however, that NIRP has also made it impossible for banks to be profitable, as negative interest rates cannot be passed on to account holders in a sustainable and consistent manner.

Nonetheless, NIRP is seen as an alternative to quantitative easing as a method of encouraging more money lending and a higher rate of money velocity, which has fallen to an all-time low in America. The cause of the decline in money velocity remains controversial and poorly understood.

One of the most popular theories is that growing wealth inequality, and a propensity towards capital preservation and risk-averse investing from ultra-high net worth individuals and institutions in the wake of the 2007-2009 Global Financial Crisis, has caused money to move from place to place less frequently, with deposits being kept in safe assets like government bonds.

NIRP is one method of reversing that, which is why the policy was mentioned as Federal Reserve chair Janet Yellen spoke to Congress on Tuesday afternoon. In her testimony, Yellen said the Fed has the legal authority to target and allow negative interest rates on bonds, but she also said that NIRP was not a policy the Fed was currently embracing and negative interest rates were unlikely to come to America in the short-term.

That does not mean the Fed is planning to raise interest rates, and in her testimony Yellen admitted that rates were likely to remain historically low. “The Committee expects that the federal funds rate is likely to remain, for some time, below the levels that are expected to prevail in the longer run,” she said.

The causes for these low rates were "restraint on U.S. economic activity from economic and financial developments abroad, subdued household formation, and meager productivity growth,” all of which were causing "the interest rate needed to keep the economy operating near its potential” to remain low by historical standards.

At the same time, Yellen admitted that the Fed could change its monetary policy if the economy improved. “Monetary policy is by no means on a preset course and FOMC participants' projections for the federal funds rate are not a predetermined plan for future policy,” she said, adding that rate policy will "depend on economic and financial developments and their implications for the outlook and associated risks."