Happy Thursday, traders. Let’s talk about everybody’s favorite water cooler topic: monetary policy!
Markets and investors of different stripes in recent weeks have been kicking around the idea of negative interest rates being implemented by the Fed in a more intense effort to support the US economy through the current crisis and (hopefully) best position it for a strong and quick recovery. Thanks in part to calls from the White House for just such a “gift,” interest rate futures markets recently had priced negative rates into the forward curve for a brief time.
Because the US has never seen negative interest rates, there are important questions that a lot of investors and traders in the gold and US Dollar markets may have. Today, we’ll take a look at the four most important.
What is Negative Interest Rate Policy?
Negative Interest Rate Policy, “NIRP”, or mostly simply “negative interest rates” is an unconventional monetary policy tool, in which central banks like the Federal Reserve take the dramatic step of dropping their policy rates below 0%. Effectively, this means that depositors (commercial and investment banks, and other financial institutions) would incur a charge for storing their reserves with the Fed in an effort to encourage those banks to loan money into the financial system instead.
The basic idea of negative interest rates pervading a developed economy like the US is definitely counterintuitive—charging depositors to leave their money at the bank, and theoretically paying borrowers to take out a loan just gets tough to wrap your head around at first—and that’s why it’s considered an “unconventional” monetary policy tool. Most of us were taught from an early age that the wise thing to do was not just to save but save our money in a bank where we would earn interest over time; nobody ever said anything about being charged a fee for saving.
Still, it’s not as though NIRP has never been used. In fact, it’s been used by both the Bank of Japan and the ECB for several years now as both of those currency systems have battled lethargic inflation (in the Eurozone) or persistent deflation (in Japan.)
Why Would the Fed Use Negative Interest Rates?
The idea behind imposing negative interest rates into the financial system is a logical—if extreme—progression from the Fed’s core monetary policy tool, the levers of lowering and raising the Fed funds rate:
- When concerned about inflation running too hot, the central bank raises interest rates so that the higher cost of funds slows the flow of money into the financial system and while also encouraging consumers to save, drawing more cash out of the system and slowing inflation further.
- In the other direction, deflation becomes an issue when the economy takes a downturn as institutions are more hesitant to take on the risk of lending while consumers are more hesitant to spend. To encourage the lending and spending in an effort to pump cash back into the financial system, the central bank lowers interest rates.
- Farther and farthest in that direction lies the reasoning for NIRP: if institutions and consumers remain unwilling to lend or spend, economic conditions will generally worsen, and those actors will become even more hesitant to participate in the financial system and this creates a deflationary spiral. If super-low interest rates aren’t proving to be enough of a ‘carrot’ to drive spending, maybe the ‘stick’ of penalizing savers by charging deposits will do the trick.
As part of these efforts to manage the financial system and business cycles, central banks have also used NIRP to specifically drive down the value of the local currency, if it’s risen high enough to hamper economic growth through exports.
What Could Negative Interest Rates in the US Mean for Gold Prices?
Honestly, we don’t know for sure. But we can make some assumptions based on how gold behaves in a low interest rate or “zero interest rate policy” (ZIRP) environment.
The main reason that investors generally believe that low interest rates imply a higher price for gold is in the comparison of the yellow metal against US Treasury debt as a store of safe value. In a time of higher interest rates, government debt will generally be a more attractive proposition for investors because they will not only be storing their money in a safe haven asset, they will also earn a return overtime for loaning that money to the government; gold, meanwhile, is a non-yielding asset. When interest rates are low, however—or extremely low, as they are now—Treasury debt loses its advantage over precious metals as an investment and we see a greater interest in gold (which pushes prices higher) because even in the almost impossible even of the US defaulting on debt (wiping out the value of any Treasuries held by investors) gold will still theoretically have a non-zero value.
It stands to reason, then, that a further push in negative interest rates in the US would be even more supportive of gold. If US Treasuries and other investments become not only non-yielding but expensive to hold on investors’ books, gold’s neutrality grows in attractiveness. (This has to be taken as a relative comparison of course, especially when considering investment in physical gold which always involves some cost of storage, either upfront or over time.)
Will We See Negative Interest Rates in the US?
Again, we can’t say for sure. With that caveat made, however, I am inclined to bet against the chances of NIRP being implemented by the Federal Reserve, primarily for the same reason that the FOMC’s own members are publicly reticent to support the idea. Namely: there’s little proof that it actually works.
Williams says Fed won't raise rates "any time soon."
On negative interest rates: "not really something that's needed right now," adding that while NIRP could stimulate spending, there are "costs in terms of functioning of the banking system."
— Brian Cheung (@bcheungz) May 21, 2020
While the Fed can use the levers of the short-term interest rates that it controls in its dealings with financial institutions, they cannot actually control how those banks behave. Even if negative interest rates would compel banks to apply ultra-low (or even negative) interest rates to products like mortgage loans, the Fed can’t force your local bank to actually issue those loans—the risk in play is that banks would end up pushing even less money into the financial system to avoid massive revenue loses. The same risk exists farther downstream: consumers, unwilling to risk getting charged to store money in a savings account may opt to stuff the mattresses with cash.
At the top, I mentioned that the Bank of Japan and the ECB have already put negative interest rates in place. What’s also true is that neither example can really be called a “success”—in the years since NIRP has been the policy in those economies, neither have been able to raise deposit rates back to even 0%.
There are also unknowns unique to the US. As I said, part of the effective mechanism of NIRP is to push the local currency lower, because negative rates increase the cost of investment from abroad driving foreign money away. That’s been the case to differing degrees in Japan and the EU, but we can’t say for sure that would function the same way in the US where the local currency is also the global reserve currency.
With the major caveats that need to be applied in cases where this super unconventional monetary policy has been implemented, and the stark fact that it’s effect on the US financial system and economy is a complete unknown, the use of negative interest rates by the Federal Reserve seems very unlikely. For now.