The Fed shot down the notion of negative US interest rates last week—again. Yet the market continues to stubbornly price them in. This is a mistake, right? It probably is, but the thought process behind this behavior is actually sound.
If the US economy remains weak into 2021, the Fed will need to ease more. With official short-term rates already at zero and quantitative easing (QE) going full throttle, it isn’t clear what other tools the Fed will use. Until the Fed’s next steps are clearer, investors have no obvious way to price additional easing measures.
That’s why the market seems obsessed with pricing negative interest rates: it’s actually a way to express a view that the Fed will need to do more to support the US economy over the next few years as it works its way back from the impact of the coronavirus crisis. Viewed that way, the logic behind pricing in a Fed move to negative rates makes sense to us, even if we think negative rates themselves are unlikely.
A breakdown of Fed chair Jerome Powell’s remarks last week illustrates a couple of key reasons the Fed might reach the point where it needs to dig deeper into the policy toolbox:
1) The Fed learned that it can—and must—run the labor market more tightly than it thought possible. The seemingly trivial link between unemployment and inflation, based on recent experience, makes this possible. And those at the bottom end of the income distribution will only benefit from the economic expansion if the labor market is run hot.
2) It might lose ground in lifting people in or near poverty if there’s no V-shaped rebound. A central bank study showed that 40% of all households making under $40,000 per year lost a job in March—with more likely in April. It took years for those households to benefit from the last expansion, and if they can’t get back to work quickly, we could see a repeat—with huge societal and economic costs.
3) The Federal Open Market Committee (FOMC) expects the economy to recover quickly, but not with a “V.” While Powell expects unemployment to fall rapidly later this year, he also sees a stretch of several years before the US economy returns to its previous level. Essentially, Powell is worried about a weak recovery from this unprecedented shock.
A Post-GFC Trajectory Could Leave the Fed Looking for More Tools
Our base-case forecast likely isn’t much different from what the Fed expects: a quick bounce as activity resumes and stimulus hits, GDP growth stabilizing at around 1.5% annualized as fiscal stimulus fades, unemployment dropping quickly but not to its previous lows, and activity remaining below its previous peak until 2022.
A slow recovery path would leave many Americans behind and risk long-term employment prospects, requiring more stimulus. Fiscal authorities are willing to run deficits of 10% of GDP or even higher during crises but will likely tighten the reins as the cycle progresses—even if only modestly. Once fiscal stimulus fades, the Fed must pick up the baton to give the expansion enough strength to reach as much of the economy as possible.
That was the post-GFC trajectory, and if we follow it again, we’ll be looking to the Fed within the next few quarters. It’s one reason why we think the Fed chair has staunchly advocated more stimulus. In our view, Powell is concerned that if the recovery isn’t robust enough, the Fed will want to do more in the coming quarters. The stronger the recovery is now, the less the Fed will have to do later.
The Fed has expressed comfort with the tools it has, but in our view these tools are effective at limiting downside economic risk but not particularly powerful in boosting growth. And that’s exactly what we think the Fed will want to do if this expansion is moderate. Forward guidance and QE are no longer unconventional policies—can they be expected to stimulate growth this time when they really didn’t last time? The Fed wants to avoid answering that question later, so it’s banging the drum for more fiscal support now.
Pricing Negative Rates: A Proxy for the Fed’s Next Tool
We think the market has this in mind when it prices negative rates. The economic outlook is likely to warrant more monetary stimulus, and the existing tool kit may not be up to the job. So, what’s next?
Because the Fed hasn’t yet been clear on that subject, the market is free to speculate. And with other central banks already using negative rates, the idea isn’t as far-fetched as it used to be. So why not bet at least some money on sub-zero rates? We don’t think it’s a coincidence that the first instance of negative rates is priced in for March 2021. Nobody seriously expects them at the moment, but what if the Fed has its back against the wall a year from now?
Even if we’re right that more stimulus will be needed, we don’t think the Fed would resort to negative rates before deploying a host of other tools first. Negative rates haven’t been particularly effective elsewhere, and they pose risks to the financial sector and money-market industry. That’s why we think it’s more likely that we’ll see more robust forward guidance, yield-curve control, a higher inflation target or maybe even a nominal GDP target rolled out first.
So, if we interpret the market’s pricing of negative rates as a statement that the economic outlook will require additional easing, it makes sense. We agree that the Fed will likely have to do more, and until we know what else it intends to do, the market’s pricing of negative rates can serve as a proxy for pricing more stimulus.
Through that prism, it makes all the sense in the world for the market to price negative rates 12 to 18 months from now—even if we still doubt that the Fed will go there.
- Eric Winograd
- Senior Economist—Fixed Income