A year ago, market analysts predicted that bond yields had nowhere to go but up. Lo and behold, the yield on the 10-year Treasury note is hovering around 1.7%; it was more than 3% at this time last year.[i]
In the United States, the Federal Reserve is in charge of setting monetary policy, or the management of interest rates and total supply of money in circulation. Fiscal policy, on the other hand, involves the taxing and spending actions by the government and is set by the national government. While each are separate independent bodies, monetary and fiscal policy share the common goal to promote economic growth and curb inflation.[ii] These days, fiscal policy is also putting pressure on monetary policy in ways inconceivable before. In a recent tweet, President Trump called on the Fed to cut interest rates to “ZERO, or less.” [iii]
In August of this year, the Federal Reserve, led by Fed Chair Jerome “Jay” Powell, cut interest rates 0.25%. This shocked the country given the Fed had done just the opposite and raised interest rates nine times between 2015 and 2018 in an effort to curb future inflation. Then last week, the Fed cut interest rates by another 0.25%.[iv] The interest rate cut worries many investors because it reminds them of the last time the Federal Reserve cut interest rates in 2008.
The Federal Open Market Committee (FOMC), the monetary policy-making division of the Federal Reserve, meets eight times a year to set the Fed Funds Rate. The Fed Funds Rate is the interest rate at which banks will loan money to each other overnight to meet their legal reserve (cash on hand) requirements. When the Fed increases the Fed Funds Rate, the cost for borrowing capital increases for banks. Therefore, banks charge more to corporations and individual consumers to borrow money – tightening monetary supply. On the other hand, when the Fed Funds Rate is lowered, banks can borrow money at a lower cost and therefore lend to consumers at a lower cost – easing monetary supply. Lowering interest rates has a ripple effect on the economy and generally speaking, the stock market does well when interest rates are cut.
During the Great Recession of 2009, the Fed cut interest rates in an effort to stimulate economic growth and consumer borrowing/spending. This kept financial markets afloat and gave middle class America access to much needed cash. Now, the Fed is cutting interest rates despite steady growth, leading many to wonder why.
President Donald Trump recently advocated that negative interest rates would further boost the economy. In this odd circumstance, consumers would actually be penalized for keeping money in the bank. For example, rather than earning 1% for keeping your money in a 1-year CD, in a negative interest rate environment, you would pay the bank 1% as a service fee for the safe-keeping of your money during the year. In such a scenario, big banks and corporations might be encouraged to spend or invest money rather than leaving it on the sidelines in caution.
The European Central Bank (ECB) has had negative interest rates for five years due to a struggling economy. Shortly after the ECB, the Bank of Japan adopted negative interest rates in early 2016. The state banks of Sweden, Switzerland and Denmark also adopted negative interest rates.[v] You might think, “No one would be absurd enough to pay a bank to hold their money!” but at the peak, approximately $12.2 trillion was held at negative interest rates.
Historically, negative interest rates have only been implemented on large corporations to punish them for parking money in cash and encourage spending or lending of money that could stimulate the economy. Traditional bank depositors were not subject to the same negative-interest fee on daily checking accounts, otherwise they might resort to keeping cash under their mattress to generate a higher 0% investment return on their money!
No one expects interest rates to go negative soon, but the door to such ideas has been opened. The Federal Open Market Committee meets again at the end of October and we’ll see what lies ahead.