By Frances Coppola
Analysts note that the widening gap between interest rates in the U.S. and its major trading partners tends to keep the dollar strong, hampering U.S. exporters and benefiting imports. There is also downwards pressure on the Chinese yuan’s exchange rate as the Chinese economy slows, raising the possibility of a significant yuan devaluation like that in 2015, which could help make Chinese imports more competitive on the world stage. The Fed has already cut interest rates twice in 2019, and analysts speculate that there might soon be negative yields on U.S. bonds.2
Central banks influence market interest rates, and through them exchange rates, by controlling the rates at which banks borrow and lend to each other. For the U.S., this rate is known as the Fed Funds rate. However, successive rounds of quantitative easing (QE) since the 2008 financial crisis left banks with large quantities of reserves, so they have little need to borrow from each other. To compensate, the Fed also uses the “interest on excess reserves” (IOER) rate as a policy tool—that’s what the Fed pays on funds that banks voluntarily deposit with it.
The Fed started paying IOER in 2008, effectively setting a “floor” on the rate banks were prepared to accept on loans to other banks and stopping the fed funds rate from falling below zero.3 However, interest rates on customer demand deposits have typically been below the IOER rate. Some analysts argue that the fact that banks can earn a small income from the spread between customer deposit rates and the IOER rate discourages them from lending, although the Fed finds no evidence for this.4 Additionally, very low interest rates on customer deposits force some people and businesses into riskier investments in search of income, which is known as “reach for yield.”5
Experts seeking to understand how the U.S. might implement negative interest rates look to the experience of economies that already have them. Other central banks have introduced negative interest rates first on their equivalent of the IOER rate, rather than on their primary policy rate. Such negative rates on deposits at central banks have several purposes. Firstly, if banks are charged to deposit money at their central bank, they may increase lending: there is evidence from Europe that banks have indeed increased lending since the European Central Bank (ECB) introduced negative rates on deposits.6 Secondly, negative IOER rates depress the yields on government bonds (for which they are substitutes), and thus lower interest rates on other bonds which trade at a spread over government bonds. In the Eurozone, yields on many bonds have fallen into negative territory since the ECB introduced negative interest rates on deposits.7 Finally, negative interest rates can weaken the currency exchange rate, discouraging imports and helping export businesses.8
However, Harvard economist and former Treasury Secretary Larry Summers says that negative interest rates can seriously affect the profitability of commercial banks, raising the risk of bank failures and financial crisis.9 Banks find it difficult to cut interest rates on customer deposits below zero, because customers have the alternative of moving their funds into physical cash, which does not bear interest although it can incur storage costs. But because larger businesses can borrow from capital markets instead of banks, banks need to cut interest rates on larger loans or face potentially crippling loss of business. To protect banks, the Bank of Japan introduced tiered interest rates in 2016 to enable banks to avoid negative interest rates on most of their reserves, provided they were doing useful lending.10 Recently, after heavy lobbying from European banks, the ECB followed suit.11
If the Fed were to introduce negative interest rates, it might follow the example of the ECB and the Bank of Japan by reducing the IOER rate to below zero while protecting banks that are doing productive lending. This could make it easier for U.S. businesses to obtain working capital, business loans, and trade finance at more affordable interest rates.
Unlike the ECB and the Bank of Japan, the Fed has stopped doing QE and has progressively shrunk its balance sheet to the point where some banks experience reserve shortages when there are high payment demands, for example when corporations need to pay taxes. As a result, the Fed Funds rate has at times risen far above the Fed’s target range. The Fed is now doing monetary operations to keep the funds rate within its target range.12
Since banks that experience dollar shortages must borrow reserves either from each other or from the Fed, the Fed could opt to cut both the Fed Funds rate and the IOER rate below zero, rather than only the IOER rate. Currently, the only central bank to have experimented with negative lending rates is Sweden’s Riksbank, which introduced a negative repo rate in 2015 to prevent the krona appreciating relative to the euro. As the Swedish economy has strengthened, the Riksbank is now looking to end negative rates.13
If both the Fed Funds rate and the IOER rate were negative, banks would effectively be paid to borrow from each other, but charged to deposit funds at the Fed. Banks holding excess funds would be encouraged to lend them to another bank at a smaller negative rate than the IOER rate. This could improve the flow of funds around the banking system and help to ease liquidity shortages, which may encourage banks to lend more to businesses. For larger businesses, a negative Fed Funds rate could also mean capital markets funding becoming much cheaper, as yields on U.S. Treasury Bonds (USTs) would be likely to drop below zero, reducing the interest rates on corporate bond issues.
However, some banks are already charging for large deposits.14 If negative rates became established, businesses could find that it becomes expensive to hold large cash balances in bank accounts or in the form of low-risk liquid assets such as USTs.
The combination of monetary operations with cuts to the Fed Funds rate tends to weaken the U.S. dollar exchange rate versus other major currencies. Both the euro and the yen rose versus the dollar when the Fed cut rates at the end of October 2019. For U.S. businesses, this could mean a boost to exports due to improved terms of trade, which may help to offset difficulties caused by rising trade tensions. A weaker dollar could also reduce credit risk for U.S. businesses dealing with overseas customers and make supply chain disruption due to supplier failure less likely.
However, if the U.S.’s major trade partners responded to Fed rate cuts by cutting their own interest rates deeper into negative territory and embarking on forms of QE, the dollar’s trade-weighted exchange rate might not weaken much, even if smaller countries maintained higher interest rates.
Negative U.S. interest rates could be a boon for U.S. businesses if they result in lower financing costs. It’s also possible that negative rates could weaken the dollar exchange rate, which could improve terms of trade for U.S. exporters and reduce business risks in international trade. However, negative rates could also result in U.S. businesses having to invest cash balances in risky assets to avoid capital erosion.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “’Give me some of that’: Trump renews call for negative U.S. interest rates,” Reuters; https://www.reuters.com/article/us-usa-trump-fed/give-me-some-of-that-trump-renews-call-for-negative-u-s-interest-rates-idUSKBN1XM2B7
2. “Investors Ponder Negative Bond Yields in the U.S.,” The Wall Street Journal; https://www.wsj.com/articles/investors-ponder-negative-bond-yields-in-the-u-s-11565521203
3. “Why did the Federal Reserve start paying interest on reserve balances held on deposit at the Fed?,” Federal Reserve Bank of San Francisco; https://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves/
4. “Interest on Excess Reserves and Commercial Bank Lending,” Federal Reserve; https://www.federalreserve.gov/econres/notes/feds-notes/interest-on-excess-reserves-and-us-commercial-bank-lending-20191018.htm
5. “A new take on low interest rates and risk-taking,” VoxEU; https://voxeu.org/article/new-take-low-interest-rates-and-risk-taking
6. “Negative rates, excess liquidity and retail deposits: banks’ reaction to unconventional monetary policy in the euro area,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2283~2ccc074964.en.pdf
7. “Update 1 – almost half of top quality euro corp bonds have sub-zero yields – Tradeweb,” Reuters; https://www.reuters.com/article/eurozone-bonds-negative/update-1-almost-half-of-top-quality-euro-corp-bonds-have-sub-zero-yields-tradeweb-idUSL5N25T26E
8. Explainer: How Does Negative Interest Rate Policy Work?” Reuters; https://uk.reuters.com/article/uk-ecb-policy-rates-explainer/explainer-how-does-negative-interest-rates-policy-work-idUKKCN1VY1D4
9. “Summers Rejects Negative Rates as Potential Crisis-Fighting Tool,” Bloomberg; https://www.bloomberg.com/news/articles/2019-01-07/summers-rejects-negative-rates-as-potential-crisis-fighting-tool
10. “Japan’s Negative Rates: the China Connection,” Coppola Comment; http://www.coppolacomment.com/2016/01/japans-negative-rates-china-connection.html
11. “ECB introduces two-tier system for remunerating excess liquidity holdings,” European Central Bank; https://www.ecb.europa.eu/press/pr/date/2019/html/ecb.pr190912_2~a0b47cd62a.en.html
12. “Fed To Increase Temporary Liquidity Available to Markets,” The Wall Street Journal; https://www.wsj.com/articles/fed-to-increase-temporary-liquidity-available-to-markets-11571867401
13. “Riksbank Seeks End to Negative Rates in Pivot Away From Herd,” Bloomberg; https://www.bloomberg.com/news/articles/2019-10-24/sweden-s-riksbank-says-it-sees-grounds-for-december-rate-hike
14. “UBS to charge super-rich for cash deposits,” Guardian; https://www.theguardian.com/business/2019/aug/06/raking-it-in-ubs-to-start-charging-super-rich-clients-for-cash-deposits