The quote from the last FOMC minutes suggested the Fed wanted a "new tool". Well here ya go Ben, take the IOER to -25bps, take 2s to -50bps and watch banks start setting LIBOR negative!! If you really want to push the portfolio balance channel this will wake up all the sleeply reserve managers with liquidity needs in USD. Of course as short rates plunge into negative territory, inflation expectations will rise sharply. It will be important to not expect too much love for the long end if this happens. And like I said above, even if this is a low probability event, the mere possibility of it happening makes levered longs in the front end a fantastic trade! No one is prepared for it. Just ask yourself how many risk management departments have shocked 2yr notes to -50bps and 3ml to -30bps in their VAR analytics. Not many!!Many investors seem to view this action positively, believing the resulting increase in bank lending will lead to higher growth and inflation. Before presenting the likelihood of such an action by the Fed, it’s important to clarify the major effects of making IOER negative.
Currently, banks are holding approximately $1.45 trillion in excess reserves:
As Mish Shedlock and Steve Keen have recently reconfirmed, banks cannot lend reserves. Reserves are brought into existence and removed from the system through open market operations. The Fed therefore controls the amount of reserves in the system, as a helpful tool in maintaining its interest rate policy. Since members of the Fed/FOMC and most economists view QE as monetary stimulus, I presume that the Fed will not elect to accompany a reduction in IOER with a policy of reversing QE and reducing its balance sheet. If the IOER becomes negative, given that assumption, banks will face a decision between increasing lending to drive up required reserves or continuing to hold excess reserves at a penalty rate.
Faced with this decision, banks may initially seek to increase lending. The drop in IOER acts similarly to a rate cut and at a negative rate may encourage banks to even extend loans that, though not directly profitable, are expected to lose less than the cost of holding corresponding excess reserves. Regardless, the amount of new borrowing required to significantly reduce excess reserves is inconceivable (a 10% reserve requirement suggests $14 trillion). The current amount of excess reserves will therefore likely remain well above $1 trillion, which is bad for banks and stocks.
Why? Well, given the current IOER rate, banks are effectively earning $3.5 billion per year, risk-free ($1.4 trillion * 0.25%). Flipping the current IOR to negative and maintaining a similar level of excess reserves suggests a yearly drain from the financial system of $3.5 billion. This reduction in profitability will hurt bank capital, which is ultimately the real constraint on bank lending.
While a negative IOER will lower bank profits, it will likely increase profits at the Fed (which are transferred to the Treasury). As Zervos points out, this policy change could also push short-term Treasury rates (at least out to 2-years) negative. If that occurs, holders of short-term Treasury notes would join banks in effectively paying the Treasury to hold funds (ie. negative interest income). Although the combination of these factors will reduce the deficit, it will simultaneously reduce net financial assets of the private sector. In that sense, a negative IOER is equivalent to raising taxes.
Absent countervailing measures to increase the deficit, a reduced deficit will also result in declining corporate profits (ex-Fed). As I’ve noted previously, the federal deficit has been the primary factor supporting corporate profits over the past few years. With a corporate profit recession already in our midsts, this decision by the Fed could result in a corporate profit depression.
In my opinion, any optimism regarding a negative IOER is badly misplaced. Rather than sparking new lending, this change in monetary policy will likely bring about the reverse by hurting bank profits and capital. By inflicting a “tax” on the broader private sector, a negative IOER could even dampen corporate profitability and incomes. In the end, a policy of negative IOER might be enough to inspire a massive sell-off in stocks and push the US economy into recession.
To end on a positive note, I believe it is highly improbable that Bernanke or the Fed enacts such a policy. Apparently Goldman agrees.
(Note: Above I mentioned Zervos’ view that a negative IOER rate would lead to negative short-term Treasury rates. I haven’t had enough time to fully think through the possibility, but my initial reaction is skeptical. Other countries currently with negative rates on short-term government debt are either engaged in a monetary union or maintaining a currency floor. Government debt in those instances therefore, apart from safety, also provides an effective call option on higher relative currency valuations. Given that the US dollar is a floating currency, investors/savers could presumably hold dollars instead of Treasuries. This could cause a rise in the dollar exchange rate but would probably keep rates from going negative (absent the Fed adjusting lower the Fed Funds rate). I’ll plan to do a follow post on this topic in the near future but, in the meantime, does anyone have helpful thoughts on this topic?)