Home / News & Videos / News / Business & Management /

Why Interest Rates May Not Fall Below Zero

Why Interest Rates May Not Fall Below Zero

July 16, 2020

Business & Management, Social Sciences & Humanities

MarketWatch — Bond investors may be setting themselves up for disappointment if they’re counting on pocketing gains from U.S. interest rates going negative.

There is a growing body of research that negative rates are counterproductive. Moreover, the Federal Reserve is aware of this research and appears to be taking it seriously.

As a result, it has become more likely that the Fed in the future will turn to other tools in its monetary stimulus tool chest besides reducing rates into negative territory.

A BGU study that points in this direction appears in the August 2020 Journal of Behavioral and Experimental Economics.

The research study was conducted by Prof. Lior David-Pur, of BGU’s Department of Economics and the head of the Government Debt Management Unit in the Israeli Ministry of Finance, BGU economics researcher Dr. Koresh Galil, and Prof Mosi Rosenboim of BGU’s Guilford Glazer Faculty of Business and Management.

Dr. Koresh Galil

The BGU researchers created a number of fascinating simulations and tests to see how investors might behave in various rate-decreasing scenarios.

Prof. Mosi Rosenboim

In one simulation, for example, interest rates were decreased to 0% from 1.0%, and in another to minus 1.0% from 0%. In theory, bonds should behave similarly in either scenario: for example, the iShares Core US Aggregate Bond ETF AGG, 0.16% with an average duration of 5.5, should in theory produce a capital gain of 5.5% in each of the scenarios.

It’s the prospect of such gains that has enticed many investors to continue to bet on bonds despite record-low yields, as bond prices rise when yields fall.

But if zero becomes the rate below which central banks are unlikely to go, then investors need to temper their enthusiasm.

The new BGU research found that these two scenarios have much different impacts on the broad economy.

In the former scenario in which rates are reduced to 0% from 1%, risk-taking across the economy increased, as you might expect.

But in the latter scenario, in which rates went below zero into negative territory, leverage decreased rather than increased.

That’s just the opposite of what central banks intend when decreasing rates below zero.

At a Federal Reserve policy meeting late last year, Fed Chairman Jerome Powell said that “the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses.”

To be sure, these statements don’t provide any certainty that the Fed wouldn’t cause rates to go negative. It is under some political pressure to do just that from President Donald Trump, who tweeted that the Fed should accept the “gift of negative rates.”

Based on statements from Fed Chairman Powell, “it is less likely that the U.S. will go below zero,” says Prof. David-Pur.

Read more on MarketWatch>>