Fed stress-tests idea of neg­a­tive in­ter­est rates

The Pak Banker - - COMPANIES/BOSS -

The Fed­eral Re­serve started rais­ing of­fi­cial in­ter­est rates in De­cem­ber. But in the stress tests that large U.S. banks have to un­dergo, the cen­tral bank is hy­poth­e­siz­ing that short-term Trea­sury yields could drop below zero. The Euro­pean Cen­tral Bank and, since Fri­day, the Bank of Ja­pan are try­ing it with pol­icy bench­marks. Though neg­a­tive U.S. in­ter­est rates are for now only in the Fed's worst-case sce­nario, they are be­com­ing a plau­si­ble down­turn as­sump­tion.

The stress tests are re­quired each year un­der the Dodd-Frank Act, and the 2016 pa­ram­e­ters for big fi­nan­cial in­sti­tu­tions were an­nounced last week. They come in "base­line," "ad­verse" and "se­verely ad­verse" fla­vors. The last is sup­posed to rep­re­sent a se­vere global re­ces­sion, and that's where the Fed has told banks to model neg­a­tive yields on short-term Trea­sury se­cu­ri­ties - em­pha­siz­ing that it's a hy­po­thet­i­cal sce­nario, not a fore­cast. Yet it's no longer look­ing out­landish. There's plenty for now to keep the Fed on a grad­ual path to­ward higher rates, in­clud­ing healthy U.S. em­ploy­ment and rel­a­tively steady growth. Even the unin­spir­ing first es­ti­mate for GDP last quar­ter, which in­di­cated a 0.7 per­cent an­nu­al­ized pace, still showed year-on-year ex­pan­sion of 1.8 per­cent. There are deep­en­ing wrinkles, though. Global mar­ket volatil­ity should mat­ter to the Fed only to the ex­tent it re­flects or causes real eco­nomic trou­ble, but the flick­er­ing of screens in real time may loom larger than that psy­cho­log­i­cally. An­other con­cern is that ac­tions like Ja­pan's de­ci­sion to set a neg­a­tive rate add to the rea­sons for the dol­lar to strengthen, po­ten­tially mak­ing U.S. ex­porters less com­pet­i­tive.

Ei­ther way, an­other down­turn will even­tu­ally come to the United States, and the op­tion of go­ing neg­a­tive may ap­peal to the Fed on pol­icy grounds, whether or not Trea­sury yields are below zero. If Chair Janet Yellen and her col­leagues haven't man­aged to raise rates much by then, there may not be much juice in cut­ting of­fi­cial rates only to zero.

Yellen in Novem­ber told a House of Rep­re­sen­ta­tives com­mit­tee that if the econ­omy took a turn for the worse, "po­ten­tially any­thing - in­clud­ing neg­a­tive in­ter­est rates - would be on the ta­ble." If the ECB, the BOJ and oth­ers have shown by then that charg­ing de­pos­i­tors is even marginally ef­fec­tive, neg­a­tive rates could shift from the se­verely ad­verse sce­nario into the Fed's reg­u­lar tool­kit.

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