The question of the legality of negative rates came up again in congressional testimony a couple of weeks ago. Rep. Patrick McHenry (R-NC) directly asked Yellen if the Fed had authority to impose negative interest rates. According to press reports, she skirted a definitive answer:
In the spirit of prudent planning we always try to look at what options we would have available to us either if we needed to tighten policy more rapidly than we expect or the opposite. So we would take a look at [negative rates]. The legal issues I'm not prepared to tell you have been thoroughly examined at this point. I am not aware of anything that would prevent [the Fed from taking interest rates into negative territory]. But I am saying we have not fully investigated the legal issues.
We know the Fed was investigating the legal issues as long ago as 2010. I would be shocked to learn that they did not investigate those issues thoroughly in the six subsequent years. Various Fed officials – including Yellen – have openly speculated about NIRP. The Fed’s legal team should be disbarred for malpractice if it hasn’t fully investigated yet. I think Yellen’s testimony was a way to deflect the potential controversy as long as possible. I believe the Yellen Fed will telegraph the markets about negative rates prior to implementing them, but evidently Yellen feels it is too soon to send that signal now.
Of course, Yellen also says she is “not aware of anything that would prevent” a NIRP move. So she may do it and then blame her lawyers if someone cries foul. By then the policy would be in place and probably irreversible. In Washington, forgiveness comes easier than permission does.
In the same testimony, Yellen hinted that the previously forecast March rate hike is probably off the table now. We will get new “dot plot” forecasts, though. It will be interesting to see how dovish they are.
As I’ve said, I am firmly convinced that the Fed will not raise the federal funds rate even to 1% this year. December may well have been the last hike we will see for some time. I can see the Fed holding steady for several months. And they are clearly getting ready to introduce negative rates during the next recession. They are already telling banks to get ready for them, too.
Y2K All Over Again?
The Dodd-Frank Act requires the Fed to conduct yearly “stress tests” on major banks. They do this by giving the banks a set of hypothetical economic scenarios. They released this year’s scenarios on Jan. 28.
The “severely adverse” scenario instructs banks to test their systems for a deep recession, a 10-year Treasury yield as low as 0.2%, 5-year notes yielding 0%, and a -0.5% 3-month T-bill yield from Q2 2016 through 2019.
Is this “severely adverse?” It’s far less adverse than what Japan has already experienced. BOJ purchases have driven Japanese government bond yields negative 10 years out the curve. Rates are also negative far out the yield curve all over Europe, even in countries that don’t deserve such rates, let alone midterm rates with even a one or a two handle.