The economy is stuck in a weak recovery and unemployment remains high, but the Federal Reserve long ago exhausted the normal tool it uses to spur economic growth.
Now, it is considering a policy change that could lead banks to charge depositors negative interest rates.
The Fed has control of short-term interest rates. During recessions, it cuts those rates to bring about greater investment and growth. However the Fed cannot make rates negative, because people will withdraw and store their money instead of letting it slowly decrease over time. This is called the zero lower bound and it limits the Fed’s power.
In recent weeks, economist have discussed the idea of how to implement a negative interest rate while preventing people from hoarding paper currency. Economist Miles Kimball has discussed creating an electronic currency and having an exchange rate between it and dollar bills. Others have discussed going cashless and eliminating paper currency altogether.
The European Central Bank (ECB) has also recently considered adopting a negative interest rate on bank deposits as well. Whether it will follow through with the policy is unclear, but it has sparked fears in banks around the Eurozone.
The goal of these ideas is to allow desired savings to equal desired investment. Right now, that would require a negative interest rate, but since it cannot happen, savings are too high and investment too low, leading to the middling growth we’ve seen over the past few years.
The larger worry is what Larry Summers brought up in his IMF talk a few weeks ago that the Fed being stuck against the zero lower bound could be the new normal. When the next recession undoubtedly hits in a few years, rates will only be slightly above zero, giving the Fed limited power to bring about a recovery. It will soon find itself stuck up against the zero lower bound once again.
However, a different Fed policy change could bring about a negative rate on deposits and test the power of the zero lower bound.
The Fed is considering tapering its asset purchases in the coming months, but its October minutes revealed that it is also interested in providing another stimulative measure when it does so. One such measure could be reducing the interest rate it pays to banks on excess reserves – those stored at the Federal Reserve – from 0.25% to 0%. In response, U.S. banks have warned the Fed that they may start charging depositors a negative rate if such a a change happens.
The banks say that doing so is a necessity to break even since they must pay small premiums to government insurance programs. At the 0.25% rate, the banks say they are breaking even, but a rate cut would put them in the red and thus force them to implement negative rates.
Such a change would be a test to see if negative rates lead to mass withdrawals that many economists expect would happen. At a -0.25% rate for example, it’s unclear if savers would take out their money en masse and risk storing it at home. At a lower rate, they may do so, but -0.25% may not be harmful enough to hoard money. However, no one knows how it would unfold.
That uncertainty is a major concern of the Fed and one of the reasons it has not cut rates below zero. It wants to avoid mass withdrawals from the banking system at all costs. To prevent this, the Fed may set up a separate facility where it would give banks a low rate on some reserves to offset the premiums and prevent banks from charging depositors to hold their money. It could also keep rates at 0.25% and choose a different stimulative measure such as lowering the unemployment threshold.
For customers, it means that soon they could be faced with two options: either watch their money slowly decrease or withdraw all their savings and find somewhere else to store them away. That’s a choice few Americans have faced.