Are Negative Interest Rates Possible in 2016?

As discussion and speculation heats up over when - and how much - the Federal Reserve will raise interest rates, the threat of negative rates in the U.S. has waned - at least for now. However, experts caution that the risk of dreaded negative rates isn't off the table just yet.

"I can't rule it out completely," said Jack Ablin, chief investment officer at BMO Private Bank. "But circumstances would have to be pretty dramatic for the Fed to push rates below zero."

As recently as May 12, Fed Chair Janet Yellen left the door open to the possibility of negative rates in the U.S., but only as a last resort.

"While I would not completely rule out the use of negative interest rates in some future very adverse scenario, policymakers would need to consider a wide range of issues before employing this tool in the United States, including the potential for unintended consequences," said Yellen, in a letter to Rep. Brad Sherman (D-Calif).

Chatter over the possibility of negative rates escalated earlier this year as the stock market sold off, jobless numbers increased, oil prices tanked and the economy seemed unable to get on firm footing. At the time, economists pontificated that it may only be a matter of time before the U.S. followed its European brethren down the negative rate rabbit-hole.

After all, negative rates are all the rage in Europe and Japan right now, after the European Central bank and national central banks in Japan, Sweden, Denmark and Switzerland cut benchmark rates below zero in the hopes of stimulating their battered economies. Their hope was that negative rates would encourage banks to lend more, which would then result in people spending more, hoarding less and investing cash in the markets. And all of this, at least in theory, would boost consumer and business spending, spur output and jumpstart wage growth.

But results have been mixed, with experts questioning if negative rates, also known as NIRP (Negative Interest Rate Policy), have worked at all.

"The jury is still out on their effectiveness," said Ablin. "Negative rates in Japan were designed to bring the yen lower, and yet, since they've instituted negative rates, the yen has traded higher."

Experts have seen no immediate reason for the U.S. to follow suit. After all, the U.S. economy has been chugging along, with the National Unemployment rate at 5% in April, the consumer price index rising 0.4% in April, new home sales jumping 17% in April from March, consumer spending ticking up 1% in April and oil prices topping the $50 a barrel mark. 

"The economy is percolating along," said Tom Stringfellow, president and chief investment officer at Frost Investment Advisors. "Negative rates would imply we do not have an economy that's gaining any kind of traction and I don't believe we're in that situation."

However, GDP growth rose at a sluggish 0.5% rate in the first quarter - its weakest in two years. To boot, though the June jobs report saw a 4.7% unemployment rate for May, the economy gained only a meager 38,000 jobs last month. That should put a damper on any plans to raise rates when the Federal Open Market Committee meets on June 14 and 15. But are these tell-tale signs of the economy negative enough to spur negative interest rates?

The U.S. economic recovery has indeed been choppy at best, and much uncertainty remains. A sharp reversal could quickly change the Fed's rate agenda.

A tumble in oil prices, a surging U.S. dollar, an uptick in unemployment, a housing downturn, slow global growth and even the upcoming Brexit vote, where Brits will vote on whether Britain will leave the European Union, could all impact a U.S. recovery.

The unemployment rate would likely have to spike above 6% and consumer spending take a major hit for the Fed to seriously consider negative rates, said Ilya Feygin, a managing director at WallachBeth Capital LLC.

"You'd have to see a complete reversal of what stabilized the economy over the past four years," said Stringfellow.

Even then, though, it would likely be a last resort, said Feygin. "There's been a lot of pushback on negative rates around the world because they're viewed as distorting markets and punishing savers and retired people." 

There's confusion among consumers too.

"There have been customers who said, 'Hey, I paid you Libor plus 2, so now if Libor is negative, you owe me $100 every month that I own the home,'" said Robert Johnson, director of economic analysis at Morningstar. "It creates all these whacky sorts of things."

With negative rates, central banks slap a tax on commercial banks that park excess reserves with them rather than paying interest on the cash. The aim is to encourage banks to reduce their balances by either giving out more loans or investing in government or other securities. This could lead to risky loans and investments, similar to what led to the 2008 housing crisis, said Feygin.

At the same time, lower rates eat into a bank's profits on those loans, forcing the bank to find other ways to offset the shortfall, such as charging people fees to hold cash in bank accounts. When this happens, consumers may opt to withdraw their cash from banks rather than pay fees, and they may either stuff their savings under mattresses or desperately turn to the stock market for higher returns. In Japan, there was a surge in people purchasing safes, noted Ablin.

This has led to concerns about cash hoarding and even runs on banks, said Ablin.

Many see another round of quantitative easing, where the government buys up trillions of dollars in government and mortgage bonds, being a better option than negative rates.

Most experts believe the U.S. will never bring in negative rates.

"I think this whole thing is so ludicrous - like asking if we're going to land on the sun anytime soon - it's that far off!" said Johnson.

Feygin doesn't see it happening in 2016 - even if the economy suddenly tanked.

"Negative rates would cause a huge political backlash," he said. "And we're in an election year."

See full coverage on the Fed's upcoming interest-rate decisions.

This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.

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