The COVID-19 pandemic has significantly impacted our economy in 2020, triggering unprecedented fiscal and monetary stimulus by the federal government and the Federal Reserve. This massive outlay of money will have long-term effects on all aspects of the economy moving forward.
It’s most obvious now in the Treasury markets, where interest rates are at or near historic lows. What’s more, the Fed has indicated that interest rates will remain low for the foreseeable future, likely into 2023.
So, if more monetary stimulus is needed, will the Fed allow some interest rates to move into negative territory?
Only Fed officials know the answer to that question, and they’re not ready to answer it yet. Still, it’s a good idea to bone up on how negative interest rates can be incorporated into the asset-liability management (ALM) process. While we don’t recommend assuming negative interest rates for budgetary purposes, creating a what-if scenario to learn what the overall effects would be on earnings, interest rate risk, and capital is a good idea.
The above table illustrates how low Treasury yields are currently. Treasury yields don’t rise above 0.50% until the seven-year point on the yield curve.
The idea behind negative interest rates is to provide a jolt to the economy. Typically, generating negative interest rates is a purposeful decision by central banks to stimulate the economy. Interest rates paid on consumer deposits may go negative (or perhaps reach a floor of zero, but with fees applied) to encourage spending and less saving. Since loan rates will be extremely low (perhaps negative in rare cases), consumers and businesses are encouraged to borrow more, spurring economic activity.
Negative interest rates are typically effective over short periods of time, but not necessarily to the extent desired. For example, Japan adopted negative interest rates in 2016, but as the following illustration shows, they didn’t prevent lower levels of economic growth than the United States (yellow highlight).
Unfortunately, changing behavior can dilute the overall effects of a negative interest rate environment. For example, financial institutions may keep more currency in their vaults to lower costs related to deposits at correspondent banks.
Why keep higher correspondent balances if interest rates are negative or fees have been increased? Consumers and businesses make the same type of decisions, perhaps keeping greater amounts of physical currency on hand to avoid higher service charges.
In Europe, there are some cases where people and businesses pay to keep physical currency in bank vaults, thereby reducing the effect of negative interest rates. “Hot money” (balances that are highly sensitive to rates) can become hotter as depositors try to gain even minimal increments of yield.
Some ideas to consider when putting together a negative interest rate scenario in your ALM model:
The likelihood of negative interest rates appears remote, but expanding your ALM modeling activities to consider the possibility is a good idea that demonstrates a proactive, forward-thinking process. It can provide valuable information to the decision makers of your financial institution. Other users of ALM data, like the Asset-Liability Committee, regulators, and auditors, will also find it useful.
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