What happens if the Fed goes negative?

The most obvious victims of a negative-rate environment are savers and retirees

The fact that the central banks of four developed countries and the eurozone already are employing negative-interest-rate policies should get the attention of the U.S. financial advice community.

It’s not that the U.S. economy is currently in the same dire straits as the eurozone, Sweden, Denmark, Switzerland or Japan. But as the list of central bankers resorting to negative rates has grown from zero less than two years ago, the pattern has become more familiar and the bankers have become more comfortable with their latest tool.

As Tangent Capital chief investment strategist Bob Rice told InvestmentNews recently, “I don’t know what’s more bizarre: negative interest rates or the fact that they’re becoming an accepted form of monetary policy.”

Earlier this month during testimony before Congress, Federal Reserve Chairwoman Janet Yellen acknowledged a negative-rate monetary policy in the U.S. is a potential option. Scholars and pundits immediately took to analyzing the legality and plausibility of the Fed going to such extremes as actually charging banks to keep their combined $2.4 trillion worth of excess reserves with the Fed.

Banks currently earn between 25 and 50 basis points on those funds, but the Fed would prefer that money be moved into circulation through loans that would help drive some inflation.

To be clear, the Fed, which in December introduced its first rate hike in nearly a decade, is not yet viewed as close to considering negative interest rates. With U.S. monetary policy currently at 25 basis points, the first move likely would be a cut back to zero, which is contrary to the Fed’s December guidance that there would be four rate hikes in 2016.

STOCK DOWNTURN

Growing evidence of a weakening economy, which has been acted out in the form of a stock market downturn to open the year, has Fed watchers revising their outlooks downward to two, or maybe three, rate hikes this year. With a March rate hike virtually off the table, sights are now set on June at the earliest.

Meanwhile, the options markets suggest there’s now at least a 10% chance the Fed will resort to negative rates within the next 12 months.

Clearly, negative rates are in the air, and that means they will eventually be on the minds of investors, including many clients of financial advisers. While there isn’t much advisers can do to deter the Fed from such an unprecedented move, they can and should be prepared to help investors understand what such an environment actually means.

It would be a fool’s errand to try and predict the next move of a Fed that has, over the past seven years, cobbled together a grubby patchwork of multi-trillion-dollar quantitative-easing programs aimed at stimulating growth. But that doesn’t stop us from applying good old-fashioned economic theory to the prospect of negative rates.

While Japan turned to negative rates primarily to devalue its currency, and Sweden has already tried to double-down on its negative-rate policy by going even more negative, the Fed likely would go negative to trigger increased lending, first and foremost.

The declining strength of the U.S. dollar that comes with falling, or negative, rates would be a nice byproduct to help U.S. exporters. And the ripple effects are virtually endless.

Banks get squeezed by earning less on cash reserves and potentially having to cover the loss associated with not passing negative rates along to savers. If banks start passing negative rates along to savers, most consumers will just keep their money under their mattresses, leaving banks without any money to lend.

The most obvious victims of a negative-rate environment are savers and retirees, who will find it impossible to keep up with even the most meager level of inflation. But a central bank that is throwing the Hail Mary pass of negative rates is already beyond worrying about such constituencies.

At that point, it will be about doing whatever it takes to ignite some inflation, and placing all bets on the promise that the best cure for low rates is low rates.