Anna Lee Ali's picture

Challenging economic orthodoxy-the federal funds rate can go below zero

In a speech in late May, Federal Reserve (Fed) chairwoman, Janet Yellen, expressed her desire to begin raising the federal funds rate this year and start the process of normalizing monetary policy. She remained sanguine, forecasting economic data would improve allowing for the first increase in the benchmark short-term interest rate since the financial crisis. However, with surprising dismal first quarter growth pointing to a contraction in the US economy combined with a weak global market, the probability of a rate hike before December seems highly unlikely.

In the past few months, economic data emerging from the US have been mixed. Last month, the Commerce Department revised its estimate for first quarter GDP growth from 0.2 per cent to -0.7 per cent. The revision was partly as a result of a weaker performance from US exporters than originally estimated owing to the strength of the US dollar. In addition, household spending (which accounts for approximately 70 per cent of the economy) was revised downwards despite lower energy prices that failed to stoke spending. Many economists are worried that the contraction may be a harbinger of a more permanent slowdown and for this reason there have been calls for the Fed to be more patient before hiking the interest rate.

Additional data released from the US Bureau of Labor Statistics earlier this month showed signs of US labour market strengthening but also confirms there is still considerable slack in the market as evident from high part-time unemployment levels.  The participation rate has also stayed low in the 62.7 to 62.9 per cent range for more than a year indicating that the labour market hasn’t fully recovered from the Great Recession. If economic growth is low, it will be difficult to achieve lower unemployment rates and the inflation target of 2 per cent set by the Fed.

While there have been signs of a rebound in the second quarter such as an increase in the sales of motor vehicles and a significant improvement in the trade deficit, the economy’s underlying momentum remains unclear. As a result, it is expected that the Fed will once again delay it decision to hike the interest rate this month when it meets.

The Fed has repeatedly said that it would conduct a “data dependent” meeting by meeting discussion to determine whether it would raise rates after six years of it being held to near zero levels. Poor economic performance in the US would continue to delay the rate hike as any increase should ideally signal an improvement in the economy. On the other hand, favourable economic data for the US in a weaker global environment, while attracting more foreign capital, causes an appreciation of the dollar which in turn weighs heavily on the US recovery.  This makes it more difficult for the Federal Reserve’s Open Market Committee (FOMC) to raise the policy rate.

Given the fragile nature of the US recovery, the Fed should be open to pursing additional monetary policy easing measures such as pushing the nominal interest rate into negative territory to encourage growth, ignite inflation and prevent further appreciation of the US dollar if the need arises. Many economists are of the view that because short term rates are already near zero levels, the Fed cannot respond to any new negative economic shocks because of the perceived lower bound set at zero. However, this is no longer true. Since 2008, some central banks around the world have held nominal interest rates below zero due to a weaker investment environment and low inflation rates. Sweden, Switzerland and Denmark have all experimented with negative interest rates without any adverse effects. Given the imminent risks arising from a possible Greek default as well as a slowdown in both China and Europe, consideration should be given to this new monetary policy tool since these problems can derail the US economic recovery.

Moving from a near zero interest rate to a barely negative one is not much more of a stimulus to encourage domestic spending and its benefits will be quite limited in this area. Moreover, the Fed may be unwilling to make this unprecedented move. However, since the US seems to be entering a cyclical slowdown, the Fed will need to revive the economy by stimulating spending. If the Fed is reluctant to cut its benchmark interest rate any further, it may be forced to return to quantitative easing measures and combine it with expansionary fiscal policy to resuscitate spending.

While many are anxious to see a rise in the federal funds rate, the fact remains that economic fundamentals do not support such an increase and it may be some time before such a rate hike is possible.