Required reading

Share

How Low Can We Go? Prospects for Negative Interest Rates

By ·September 17, 2019
Williams College

The Issue:

There is increasing speculation regarding whether the Federal Reserve might set a negative target for the federal funds rate should the economy enter a recession. If it did, the Fed would not be the first central bank to do so.

The Facts:

  • The purpose of setting a negative funds rate target would be to provide additional monetary stimulus. With the federal funds rate already so low, there is very little room for further rate cuts, assuming the Fed stops at zero, as it has in the past. The chart illustrates the Fed’s quandary. The amount of monetary stimulus is measured by the real (inflation adjusted) federal funds rate. If the Fed were to cut the funds rate target to zero, the Fed would be able to achieve only a 2.1% reduction in the real funds rate – far less than in previous recessions. If the Fed could set a negative funds rate, it would be able to achieve a lower real funds rate, thus giving it more ammunition with which to fight a recession.
  • The federal funds rate could become negative if the Federal Reserve charged banks for holding their reserve balances. There is a practical limit on how far below zero interest rates can fall. Commercial banks and households will be willing to pay for the privilege to hold deposits because holding cash is costly and inconvenient, but only up to a point. Pushing rates too far below zero will eventually lead individuals and institutions to move a significant volume of funds into cash — such as the proverbial cash under the mattress — in order to avoid the cost of holding deposits.
  • The stimulative effects of a negative federal funds may be limited. In order for a negative policy rate to have the desired effects, other interest rates, such as those on bank loans, corporate bonds, and home mortgages, would also have to fall. The 10-year Treasury rate, the benchmark for corporate and mortgage rates, is already near its historic lows (less than 2%) so there is not much scope for further reductions. Moreover, negative interest rates entail banks paying the central bank, which squeezes profits and could dampen loan supply.

What this Means:

The Fed’s self-imposed zero lower limit on the target has in the past constrained the scope for rate cuts during recessions. Given the low interest rates and low inflation that have persisted since the end of the Great Recession, the Federal Reserve does not have much room to stimulate the economy with traditional monetary policy tools should the economy fall into recession. A negative rate policy would complement the Quantitative Easing (QE) and forward guidance measures it implemented in 2009, during the previous recession. The U.S. economy is not yet at that point, however, as GDP growth is steady and the unemployment rate remains low; in fact, the current funds rate target is still well below what would normally be warranted by economic conditions. In addition, concerns about the policies’ efficacy and possible adverse impacts on the banking system suggest that the Fed is likely to be very cautious in implementing a negative rate policy.

Read more

Share

Is the Rise in U.S. Corporate Debt Cause for Concern?

By ·September 8, 2019
Brandeis University

The Issue:

The total value of nonfinancial corporate debt in the United States now stands at or near all-time highs. Loans account for a large proportion of corporate debt. Unlike bonds, whose terms are relatively transparent and therefore have risks that can be more readily gauged, loans are private contracts between two parties and their terms and risks may be less well understood. Should the growth of debt, or its composition, be a source of concern?

The Facts:

  • The absolute amount of nonfinancial corporate debt and corporate debt as a share of GDP have risen since the financial crisis: from 65 percent of GDP in 2013 to 74 percent of GDP in early 2019. This growth in debt appears also to reflect growing firm profits and firm values. But corporate debt as a share of the total financing mix, measured using the market values of these financial instruments, appears to be falling over time, with a slight uptick in the past several quarters that is dwarfed by the longer-horizon decline (see chart). 
  • It is important to pay attention not just to the amount of debt, but also different facets of its composition. There is concern with the form debt is taking. Lenders who offer loans typically protect their interests with “covenants” which tie borrowers’ hands and – when well-designed – can reduce a lender’s risk. The Moody’s rating agency has been measuring and recently publishing commentary about deteriorating covenant quality in the highest-risk parts of the corporate loan market. A trend that points toward willingness on the parts of at least some investors to accept minimal covenant protection when they lend to corporate borrowers.   
  • There is also concern that some debt may not be financing productive investment. The use of funds raised through debt for both acquisitions and stock buybacks are each currently about four times larger than the use of funds for purchasing capital expenditures or for intangible assets. Using loans or bonds to finance capital expenditures and intangible assets like ownership of intellectual property can help companies grow in the future. In contrast, stock buybacks—which are used to return wealth to stockholders — have a less-direct benefit for the future prospects of a company. 
  • The pattern of those who hold debt may also matter for overall financial stability. The average leverage (amount of borrowing relative to the earnings of a firm) for the economy as a whole can mask very different levels of leveraging across firms.

What this Means:

The amount of corporate debt has been growing since the recovery from the Great Recession, but this aggregate growth in the amount of debt appears mostly consistent with the robust growth in corporate profits. Debt as a share of the total firm financing mix is much lower today than it was during the 1980s and early 1990s. The mix of debt tilts in the direction of loans versus publicly-traded bonds, and because well-crafted covenants are an important tool for protecting against loss, it is important to continue to pay attention to changes in covenant quality over time. Finally, rising interest rates could quickly erode the profitability of firms that have borrowed at floating rates or using short-term debt.

Read more