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Will the Next Fed Meeting Lead to Negative Interest Rates?

| MoneyRates.com Senior Financial Analyst, CFA
min read

Percent-sign-US-dollarThis preview of next week's FOMC meeting offers some tips about what to expect, including:

  1. What unemployment and inflation say about whether the economy is in recession
  2. How the Fed left itself little room to maneuver on interest rates
  3. Whether negative interest rates are an option for the Fed
  4. What this means for consumers - and what they can do about it

The Federal Open Market Committee (FOMC) will meet next week with its hands tied.

The coronavirus pandemic caused unemployment to soar and inflation to dive. Normally, that would call for a fed rate cut.

However, the federal funds rate was already low going into this crisis, and is now near zero. That leaves the Fed without its traditional go-to move to fight a recession.

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Unemployment, Inflation Numbers Signal Recession

COVID-19 has had a devastating impact on the job market.

Seasonally adjusted unemployment rose by 20 million jobs in April alone, driving the unemployment rate to around 15%.

Along with the job market, inflation also dropped severely in April. The Consumer Price Index fell by 0.8%, its biggest drop since 2008.

Of course, 2008 was in the midst of the Great Recession.

Although the official numbers are not out yet, fears of recession seem well-founded at this point. It is certain that the economy is in a recession once again. Real GDP growth declined at a 5% rate in the first quarter of 2020, and things have only gotten worse since.

Decisive action by the Federal Reserve played a role in pulling the economy out of its nosedive in the Great Recession. This time around, the Fed must fight the crisis without one of its key weapons.

Federal Interest Rate Cut? If Only It Were That Easy

From late 2007 to the end of 2008, the FOMC responded to worsening economic news by cutting interest rates ten times, totaling over 5%.

Interest rate cuts are a classic monetary policy tool for pumping life into the economy. If you make borrowing cheaper, people are more likely to borrow - so economic activity should increase.

The two specific things the Fed is trying to manage through its monetary policy are employment and inflation. Recent developments suggest both are in drastic need of help.

The numbers for employment and inflation

Based on Bureau of Labor Statistic numbers going back to 1948, the official unemployment rate has never been higher. It has never suffered a worse one-month rise than it did in April.

As for inflation, the FOMC tries to maintain an inflation target of around 2%. It's a balancing act: High inflation makes things more expensive for consumers, but falling prices signal a weak economy and discourage further economic activity.

Due to the coronavirus pandemic, prices are falling sharply. The Consumer Price Index fell by 0.4% in March and by 0.8% in April.

So if both the job market and consumer prices are weak, why doesn't the Fed just do what it did in the Great Recession and aggressively lower interest rates?

Unfortunately, the Fed has less latitude to do that this time around.

The Fed interest rate was 5.25% heading into the Great Recession. By bringing that rate down close to zero, the Fed was able to cut rates by 5%.

Normally after cutting rates in a recession, the Fed would raise rates again as the economy started to grow. However, despite an exceptionally long economic expansion, the Fed was slow to do a rate hike over the past decade, leaving the Federal Reserve interest rate unusually low.

The Fed interest rate began 2020 below 1.75%. In March, the FOMC cut rates close to zero; but since this was a drop of much less than 5%, it had much less impact than it did in the Great Recession.

Negative Interest Rates Are Unlikely (But Not Out of the Question)

If rates are already near zero, could pushing them into negative territory be a way to lower them further?

After all, some central banks have done so. However, the concept is unproven.

Japan, for example, has had near-zero interest rates for much of the past 20 years, including below zero for the past few years. However, over those 20 years, it has rarely achieved even a 2% annual growth rate.

Negative interest rates may work on a limited basis such as when banks charge fees that exceed the interest they pay on some customer accounts. Beyond that, it is probably wishful thinking to believe they would provide widespread economic stimulus.

For one thing, few lenders would have any incentive to write loans if they had to pay rather than receive interest to do so.

For another thing, the nature of this crisis is that economic activity is being largely constrained by concerns about physical contact. Lower interest rates would do nothing to help that.

Fed Chair Jerome Powell has said that he does not think negative interest rates would be an appropriate solution for the U.S. economy. One thing to look for from next week's meeting is whether he elaborates on this view.

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What This Means for Consumers

With the Fed less focused on interest rate cuts than in past economic crises, what does next week's meeting mean to consumers?

While no further change in interest rates seems likely, consumers looking at the conditions facing the Fed should consider two possible responses:

Certificates of deposit (CDs) may be worth a look

CDs typically involve committing to an interest rate for a period of months or years. Normally, people are hesitant to lock in rates when they are low.

However, CDs generally offer better rates than savings or money market accounts and, given the drop in consumer prices, they may be worth a fresh look.

With the CPI down by over a percent in just two months, suddenly CD rates look a lot more attractive on an inflation-adjusted basis.

It's a good time to borrow - if your finances can handle it

Since low interest rates make borrowing cheaper, this could be a good time to borrow - but only if you meet a couple conditions:

  1. Your credit should be good to excellent. The worse the economy gets, the more reluctant lenders are going to be to lend to anyone but the safest credit risks.
  2. Your job security and income should be strong enough that you feel safe from a layoff or pay cut that would make it difficult to meet your loan obligations.

As part of next week's meeting, the Fed is scheduled to update its economic projections for the next few years. However, it set those projections aside when March's regular FOMC meeting was cancelled, and it remains to be seen whether it will update them this time.

If the Fed once again does not feel it can make projections about the future of the economy, it will be another reminder of just how uncertain the current environment is.


Previous Federal Reserve Board Updates articles:

FOMC Date2020 FOMC Meeting Update Articles
04/23/2020The Federal Reserve in Crisis: What's Next?
03/12/2020Next Fed Meeting Won't Solve Global Economic Crisis, But Here's What Consumers Can Do
01/22/2020January 2020 Fed Meeting - More Than Meets the Eye?

 

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