Can The Fed Legally Impose Negative Rates? - Gainesville Coins News
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Can The Fed Legally Impose Negative Rates?

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Can The Fed Legally Impose Negative Rates?
© Skypixel | Dreamstime.com - Negative Interest Rates

With stock markets melting down around the world, and the global economy in a bear market, central banks in Europe and Japan have done the unthinkable - lower benchmark interest rates to below zero. The theoretical positive effects have so far been outweighed by the real negative effects. This can be seen in the financial sector, where already slim profits are being squeezed to the point that the New York Times says that banks and money market mutual funds may cease to exist.

So why does the Fed hint that it may go down the same path trodden by the ECB and Bank of Japan?

Why Would The Fed Impose Negative Rates?

rose-colored-glasses Love these Fed-supplied rose-colored glasses!

Analysts across the world see negative interest rates as the last, desperate ploy by central banks to control the markets. However, about the only thing that has gone to plan is a devaluation of the domestic currency. In economies such as Switzerland and Japan, safe haven demand for their currencies can even reverse that. The central banks expect that negative interest rates will prod banks into lending out their excess reserves instead of paying to keep it at the central bank. This would be expected to stimulate the economy, and get inflation back on track

The unintended negative effects of negative rates are market volatility, a collapse in financial stocks, and a contraction in lending instead of an expansion. They also give the impression that the central bank's efforts with QE and zero interest rates have failed at rescuing the economy, which erodes confidence in the powers of the central bank. The Wall St. Journal calls this the "doom loop" of negative feedback between the Fed and the banks, which erodes confidence in the economy, and in the Fed.

DoomLoop

Can the Fed Legally Implement Negative Rates?

legal-law-judgement

In testimony before Congress shortly after the Japanese went negative, Fed leader Janet Yellen said that she would not rule out implementing negative rates in the US. However, there is actually some uncertainty over whether the Fed has the legal authority to charge banks fees in excess deposits (i.e. impose negative interest rates.) Even the Fed itself is uncertain on this point.

Bismarck once said, "it is best not to know how laws and sausages are made." However, a dive into the nitty gritty of the relationship between the Fed, the banks, and "government sponsored entities" like Freddie Mac and Fannie Mae show how the Fed could rapidly end up with huge losses if it implements negative benchmark interest rates.

In the same article, JP Koning spells out the legal uncertainty regarding the Fed and negative rates:

Until October 2008 the Fed was legally prohibited from paying interest to banks. Any bank manager who left reserves on deposit at the Fed earned 0%. This changed with the passage of the  Financial Services Regulatory Relief Act of 2006 which bolted Section 19(b)(12) onto the Federal Reserve Act allowing banks to "receive earnings to be paid by the Federal Reserve Bank." As a direct result of 19(b)(12), the Fed has been paying interest of 0.25% for a number of years, a rate that was recently increased to 0.5%. Not only did Section 19(b)(12) provide the Fed with the ability to pay interest on reserves, it also gives it the technical means to pay negative rates on reserves. Now there is some controversy whether the wording in Section 19(b)(12) authorizes a negative rate; for instance, it mentions the paying of earnings to banks, not the payment of negative earnings:

In a move that spooked the markets, the Fed ordered banks to include a scenario of negative interest rates in their upcoming stress tests, to gauge how well they could cope. This caused turmoil in two ways: if the Fed is getting ready to roll back December's rate hike, it shows a lack of faith in the economy; and if they aren't, they are causing market turmoil for no reason.

Unlike other aspects of monetary policy, the Big Banks may have legal recourse to challenge the implementation of negative rates in the courts. It will depend on whether the Fed figures out how to make negative rates work in the existing financial system, or whether they simulate negative rates by charging fees on excess bank deposits. If their actions can be cast as a regulatory matter, the banks could sue.

Is It Too Late For the Fed To Go Negative?

We could draw some parallels between central banks charging negative interest rates, and the collapse of the Gold Standard in the 1930s. The major goals of both events were currency devaluation and economic stimulus. They both happened during a global recession. Because they both hinge on currency devaluation, the ones that move first get the most advantage, while those who move last can only hope to remove their disadvantage.

Hopefully, some miracle like oil prices doubling or China getting its economy in order will remove the temptation of negative rates from the Fed. Or, maybe the failure of NIRP in other large nations will become obvious, and the Fed won't take that last, desperate step.

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product

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