Todd Keister of the Federal Reserve Bank of New York wrote recently on the banks's "Liberty Street Economics Blog" a post entitled, "Why Is There a "Zero Lower Bound" on Interest Rates?." It says, "Economists often talk about nominal interest rates having a "zero lower bound," meaning they should not be expected to fall below zero. While there have been episodes -- both historical and recent -- in which some market interest rates became negative, these episodes have been fairly isolated. In this post, I explain why negative interest rates are possible in principle, but rare in practice. Financial markets are generally designed to operate under positive interest rates, and might experience significant disruptions if rates became negative. To avoid such disruptions, policymakers tend to keep short-term interest rates above zero even when trying to loosen monetary policy in other dimensions. These policy choices are the source of the zero lower bound."
Keister continues, "The standard description of the zero lower bound begins with the observation that the nominal interest rate offered by currency is always zero: If I hold on to a dollar bill, I'll still have one dollar tomorrow, next week, or next year. If I invest money at an interest rate of -2 percent, in contrast, one dollar of saving today would become only ninety-eight cents a year from now. Because everyone has the option to hold currency, the argument goes, no one would be willing to hold some other asset or investment that offers a negative interest rate. This argument is only part of the story, however. Safeguarding and transacting with large quantities of currency is costly.... Many individuals would likely be willing to keep funds in deposit accounts even if these accounts pay a negative interest rate or charge maintenance fees that make their effective interest rate negative."
He explains, "Large institutional investors are in a similar situation. They use a variety of short-term investments, such as lending funds in the "repo" (repurchase agreement) market and holding short-term Treasury bills, in much the same way individuals use checking accounts. These investments will remain attractive to large investors even at negative interest rates because of the security and convenience they offer relative to dealing in currency. Some repo rates did in fact become negative in 2003 ... and again more recently.... In other words, market interest rates can move somewhat below zero without triggering a massive switch into currency. Nevertheless, central banks typically maintain positive short-term interest rates even while using less conventional tools (such as large-scale asset purchases) to provide additional monetary stimulus."
The NY Fed blog adds, "The Federal Reserve, for example, currently pays an interest rate of 0.25 percent on the reserve balances that banks hold on deposit at the Fed. The ability to earn this interest gives banks an incentive to borrow funds in a range of markets (including the interbank market and the repo market) and thus has the effect of keeping market interest rates positive most of the time. The Federal Open Market Committee (FOMC) discussed the idea of reducing the interest on reserves (IOR) rate at its September meeting, but no action was taken. Reducing this rate would tend to lower short-term market interest rates and might push some rates below zero. The minutes from the meeting report that "many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.""
Finally, Keister says, "Some examples of areas where disruptions could potentially arise in U.S. financial markets are: Money market mutual funds: Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers."
In other news, Fitch Ratings released a statement entitled, "Corporate Commercial Paper Filling Money Market Void". It says, "While waning demand for bank-issued commercial paper (CP) has reduced investor exposure to short-term financial sector obligations in recent months, U.S. corporate borrowers have begun, in part, to fill an important void in the CP market. Fitch Ratings sees the potential for a recent pick-up in Tier 2 (F2) corporate issuance to continue as money market funds and other institutions reach for yield in short-term credit markets."
They add, "Faced with an unhappy choice between near-zero rates on short-term Treasury obligations and a desire to limit further exposure to higher yielding bank instruments subject to sovereign contagion risk, CP investors have continued to look beyond traditional issuers to meet performance objectives. Given their healthy liquidity positions and improved leverage profiles, many Tier 2 corporates, with low investment-grade issuer default ratings (IDRs), have become increasingly attractive as alternative short-term investments. Although the aggregate amount of CP outstanding has been cut sharply since 2007, Federal Reserve data have continued to track a steady rise in nonfinancial CP issuance, particularly in the months since April, as the European debt crisis has intensified."
Fitch explains, "Of particular interest is the rising level of Tier 2 CP outstanding. While the CP market is still dominated by highly rated Tier 1 companies, Tier 2 CP outstanding has grown steadily in recent months.... Under SEC Rule 2a-7, money market exposure to eligible Tier 2 CP is limited in scope. However, given the small amount of Tier 2 paper relative to Tier 1, issuance levels may have room to grow. As of Nov. 16, total Tier 1 CP eligible under Rule 2a-7 totaled $771 billion compared with $69 billion of Tier 2 paper.... Corporate CP still represents only about 20% of total obligations in a market dominated by banks and asset-backed paper. However, continued shifts in investor risk preferences may increase corporate CP issuance further and reduce short-term borrowing costs for some nontraditional issuers."
