The Fed Wants to Test How Banks Would Handle Negative Rates

Was Fed December Rate Hike a Mistake?
  • Three-month Treasury bill rate falls to negative 0.5 percent
  • Very adverse scenario posits harsh worldwide recession

As interest rates turn negative around the world, the Federal Reserve is asking banks to consider the possibility of the same happening in the U.S.

QuickTake Negative Interest Rates

In its annual stress test for 2016, the Fed said it will assess the resilience of big banks to a number of possible situations, including one where the rate on the three-month U.S. Treasury bill stays below zero for a prolonged period.

"The severely adverse scenario is characterized by a severe global recession, accompanied by a period of heightened corporate financial stress and negative yields for short-term U.S. Treasury securities," the central bank said in announcing the stress tests last week.

In that particular simulation, the unemployment rate doubles to 10 percent, the same level it reached in the aftermath of the last financial crisis.

Three-month bill rates have slipped slightly below zero several times in recent years, including in September after the Fed delayed rate liftoff amid global financial market turmoil, touching a low of minus 0.05 percent on Oct. 2.

But in the stress test, banks would have to handle three-month bill rates entering negative territory in the second quarter of 2016, and then falling to negative 0.5 percent and holding there through the first quarter of 2019.

Not a Forecast

"This scenario does not represent a forecast of the Federal Reserve," the central bank said. It also assumes "that the adjustment to negative short-term rates proceeds with no additional financial market disruptions."

Fed officials have made clear that they are a long way from contemplating a reduction in rates below zero in their benchmark overnight policy rate. Some, though, have suggested they’d be more open to such a move than in the past should the economy deteriorate significantly.

The central bank left its target range for the federal funds rate unchanged at 0.25 percent to 0.5 percent last week after raising it in December for the first time since 2006.

U.S. policy makers decided against pushing rates below zero during the financial crisis partly because of concern it could lead to dangerous dislocations in the money markets.

European Experience

Since then, the European Central Bank and the central banks of Switzerland, Sweden and Denmark have nudged some official lending rates negative without such repercussions, and Fed officials have publicly taken note.

The Bank of Japan became the latest monetary authority push rates into negative territory last week in an effort to spur lagging growth and increase too-low inflation.

Former Fed official Roberto Perli cautioned against drawing conclusions about future Fed actions from the inclusion of negative U.S. rates in the stress test scenario.

"It doesn’t signal anything" about future monetary policy, said Perli, a partner at Cornerstone Macro LLC in Washington.

Nevertheless, it is "another sign that the Fed would not be entirely adverse" to reducing its target rate below zero should economic conditions warrant, he said.

Bill Dudley

New York Fed President William Dudley said last month that policy makers were "not thinking at all seriously of moving to negative interest rates.

"But I suppose if the economy were to unexpectedly weaken dramatically, and we decided that we needed to use a full array of monetary policy tools to provide stimulus, it’s something that we would contemplate as a potential action," he said on Jan. 15.

Fed Vice Chairman Stanley Fischer said Monday that foreign central banks that had resorted to negative interest rates to stimulate their economies had been more successful than he anticipated.

“It’s working more than I can say I expected in 2012,” he told the Council on Foreign Relations in New York. "Everybody is looking at how this works," he added.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE