Are U.S. Interest Rates Headed to Zero?

Larry Summers, the former U.S. Treasury Secretary and ex-president of Harvard University, is concerned about the possibility of such a scenario.

“Black hole monetary economics — interest rates stuck at zero with no real prospect of escape — is now the confident market expectation in Europe and Japan, with essentially zero or negative yields over a generation,” Summers wrote in a series of recent tweets ahead of the Kansas City Fed’s annual policy retreat in Jackson Hole, Wyoming. “The United States is only one recession away from joining them.”

Bank of America Merrill Lynch Global Rates Research Strategist Ralf Preusser is also concerned about U.S. interest rates falling to zero amid a global economic slowdown.

“Concerns are rising that by the time decisive action is taken by global central banks and/or on the trade front, in our view it may be too late to push the global economy back on track,” wrote Preusser in a recent report. “Furthermore, U.S. yields in particular may be stuck in a catch-22 between trade rhetoric and central bank action:

• If monetary policy succeeds in supporting growth and equity markets, particularly in the US, then we risk seeing further escalation in the trade war requiring further cuts until rates are at zero (a conventional easing scenario)
• If monetary policy support proves ineffective in supporting the US, then the Fed will be forced to cut further until rates are zero (risking a ”Japanification”scenario for the U.S. curve and the broader DM complex). (DM refers to developed markets.)

Preusser was referring to short-term U.S. rates. The current Fed Funds rate is set in a range between 2% and 2.25% following the Fed’s first rate cut in over 10 years in late July. Market forecasts calls another two or three cuts before end, starting with another 0.25% cut at the Fed’s net meeting in mid-September.

But the minutes from the last Federal Open Market Committee meeting suggest some uncertainty about future Fed rate policy. In addition to the two dissenters at the last FOMC meeting — Boston Fed President Eric Rosengren and Kansas City Fed President Esther George, who opposed any change in rates — there were other participants in the meeting who favored no change in rates and two  who preferred a 50-basis point cut.

Attention now has turned to Fed Chairman Jerome Powell, the keynote speaker at the Kansas City Fed’s Jackson Hole, Wyoming, retreat on Friday.

In his speech, Powell noted that the question now for the Fed is how it “can best support maximum employment and price stability in a world with a low neutral interest rate,” meaning a rate that neither stimulates nor restrains growth.

“The current  era has been characterized by much lower neutral interest rates, disinflationary pressures, and slower growth … and risks “lengthy, difficult-to-escape periods in which our policy interest rate is pinned near zero.”

Uncertainty about trade policy is weighing on U.S. and global growth but  “setting trade policy is the business of Congress and the Administration, not that of the Fed,” said Powell. “There are no recent precedents to guide any policy response to the current situation.”

Powell said the Fed is conducting a public review of our monetary policy strategy, tools, and communications — the first of its kind for the Federal Reserve, “to address this new normal,” which he expects to conclude next year and publicly share the results.

Ahead of Powell’s speech Summers tweeted that the impact of Fed rate cuts on aggregate demand in a global work of low to negative rates world may have “declined sharply,” and could decline further with additional rate cuts as rates for multiple reasons.

Among those reasons: rate cuts don’t address structural issues that reduce aggregate demand and don’t impact companies that have no debt to service; rate cuts hurt the profitability of banks and increase the possibility of bank failures; and they  borrow demand from the future as companies and consumers accelerate investments and durable goods purchases.

“The right issued for macroeconomists to be focused on is assuring adequate aggregate demand,” tweeted Summers. “It is dangerous for central bankers to suggest that they have this challenge under control or that their current toolkit will be able to get it under control.”

That toolkit now includes limited ability to cut rates during the next recession because current rates are so low.

“In every U.S. recession since the 1970s the Fed Funds rate was cut more than 500 basis points and the real rate, adjusted for inflation fell more than 400 basis below the neutral rate,” tweeted Summers. (The neutral rate is the rate at which Fed Funds neither stimulate nor restrain growth.) “Now the maximum feasible cut is 200-300 basis, bringing real rate only 150-250 basis points below neutral,” 

While financial markets wait for the Fed’s next move on short-term interest rates, long-term bond yields remain sharply lower. The 10-year Treasury yield fell below the two-year Treasury yield in mid-August — a well-tested and well-regard recession signal —   causing the Dow to suffer its worst performance this year, falling 800 points.

On Thursday, the 10-year Treasury finished at almost the same yield as the two-year Treasury, at 1.61%, following several more inversions since mid-month. Two-year and 10-year rates fell further on Friday, both trading near 1.50% in the mid-afternoon.

BofA Merrill Lynch strategists are now targeting a 1.25% yield for the 10-year Treasury by year-end.