As Central Banks Go Negative, Can the Fed Follow?

By Brian Kesten

The Federal Reserve increased the federal funds rate for the first time in nearly a decade this past December, raising the target rate from 0-0.25% to 0.25-0.5%. Yet the Fed’s historic move to raise rates is dwarfed in significance by the actions of the European Central Bank (ECB), the Bank of Japan (BoJ), and the Swedish Riksbank: the unprecedented negative interest rate policy. This marks the first known monetary move below the zero lower bound, previously thought to be the hard floor on interest rates.

In effect, the central banks in Europe and Japan are charging fees for holding required and excess reserves parked at the central bank by domestic financial institutions. Austerity programs and fiscal deficit fears have stifled growth in the Eurozone and Japan, so the central banks in these nations essentially bear the mantle of stimulating economic growth, with fiscal spending and tax reductions off the table. Before implementing negative interest rates, the ECB, the BoJ, and the Riksbank engaged in quantitative easing programs, aimed at flooding financial institutions with liquidity that the commercial banks could invest in domestic industries in the form of business and home loans.

By implementing negative interest rate targets now, the ECB, the BoJ and the Riksbank banks hope to force banks to make loans or effectively pay a tax on the inactive reserves generated through the central bank’s purchases through quantitative easing. Negative interest rates are not popular with everyone, and some call the tactic a “dangerous experiment.”

The Fed had its own quantitative easing program from 2009 to 2014, which led to a $3.5 trillion dollar increase to the Fed’s balance sheet. Unlike its central bank counterparts around the globe, the Fed moved to increase interest rates in 2015, despite low inflation and lagging wage growth. In fact, the most recent projections show that Federal Open Market Committee members, which set the target federal funds rate, anticipate increasing the rate by roughly one percent each year through 2018 before flattening out at three or four percent.  

Many commentators questioned the Fed’s choice to increase rates, including Nobel prize winning economist Joseph Stiglitz, former Treasury Secretary Lawrence Summers, IMF Managing Director Christine Lagarde, and China’s Finance Minister Lou Jiwei. The United States’ action to increase rates is out of step with the rest of the world economy.

Proponents believe that negative interest rates could jumpstart the U.S. economy by pushing cash into the market. Since 2010, the U.S. money supply has skyrocketed to unprecedented levels, which are mirrored in the mountain of excess reserves held at the Fed earning interest. Negative interest rates would incentivize financial institutions to put these funds to use in the real economy, and could help meet the Fed’s underperforming inflationary goals. 

So, could the Fed adopt negative interest rates, if the time came? Maybe not.

To effect negative interest rates, the Fed can’t simply set the rate like a price control. Instead, the Federal Open Market Committee (FOMC) acts to pull the market in the desired direction through buying and selling treasury securities and bank reserves. Unfortunately, buying and selling activities can’t pull the federal funds rate into the negative. The Fed would need to effectively enforce an industry-wide tax on bank deposits by charging financial institutions to hold money at the Fed, who would then pass that cost on to depositors and other institutions.

The Fed might not have the necessary tools. In 2006, Congress passed the Financial Services Regulatory Relief Act authorizing the Fed to pay interest on reserves beginning in 2011, which the Emergency Economic Stabilization Act accelerated to 2008. It is not clear if this authority to “pay interest” could also allow the Fed to charge interest in affecting a negative interest rate.   

In fact, Fed Chair Janet Yellen expressed some doubt about the Fed’s power to do so on a recent hearing before the House Financial Services Committee. This sentiment echoed a 2010 memo just released by the Fed, which considered the legality of negative interest rates and the impact on the market for treasury securities. Additionally, the global economy, and particularly the presence of competing financial institutions, could obstruct the Fed’s ability to implement negative rates.

If the Fed does decide to impose negative rates one day, the cleanest path would be to seek Congressional action authorizing the Fed to charge a tax on reserves held at the Fed. Some scholars doubt the constitutionality of the FOMC altogether. Others have noted that the Fed has stretched its statutory authority in the past to meet its objectives from trading in short term bills in the early 20^th century, to trading in foreign currency in the mid 20^th century before it was legal, to the controversial “Maiden Lane” bailouts of 2008.