From ZIRP to NIRP: What's the Fed's next move?

Negative interest rates in the U.S. may seem like a far-fetched idea, but the Federal Reserve is telling banks to prepare, just in case.

For the first time ever, the governing agency and U.S. central bank is requiring banks to include, in a round of stress tests commencing this year, to prepare for the possibility of negatively yielding Treasury rates. The scenario is purely hypothetical and not a forecast, according to a Jan. 28 Fed news release .

However, the development is part of a larger scenario of a world where zero rates are morphing into negative rates.

Janet Yellen discusses the Fed's first interest rate hike in 9½ years, Dec. 16, 2015, in Washington.
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Janet Yellen discusses the Fed's first interest rate hike in 9½ years, Dec. 16, 2015, in Washington.

This is how beggar-thy-neighbor monetary policies work, and perhaps why they ultimately fail.

One nation mired in an economic slump decides that the best way out is to devalue its currency, cheapening its exports and thus making them more attractive in countries that have higher-yielding currencies and, consequently, more buying power.

Seeing the success that country has, another seeks to emulate. And then another. And another. And another. In order to stay ahead of the game, central banks keep devaluing until there's nothing left, tangibly at least, to devalue, and negative interest rates come into play.

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Pretty soon you have nearly a third of all sovereign debt holding negative yields. In turn, what seemed like a powerful tool to stimulate lending and export-led economic growth becomes a toothless tiger that global central banks continue to deploy, the latest being in Japan. Suddenly, zero interest rate policy, or ZIRP, has morphed into negative interest rate policy, or NIRP.

This is no dystopian hypothetical. This is what central banking has become in a global economy beset by meager growth.

Worries are growing that the Federal Reserve soon could bring NIRP to U.S. rates. Japan went to NIRP last week, and the yield on the 10-year Japanese government bond went negative overnight Monday for the first time ever.

"It appears that NIRP is becoming the main policy tool for a number of major central banks as they battle falling inflation, rising currencies and economic weakness," Jeffrey Kleintop, chief global investment strategist at Charles Schwab, said in an analysis. "The effectiveness of slightly negative interest rates is far from assured, and increasingly negative interest rates may not just weigh more heavily on the stock market, but on drivers of economic growth as well."

Read More Negative rates in US? Here's why it could happen

Indeed, ZIRP seemed to pull stock markets higher, but the spreading of NIRP has coincided with a sharp global equity decline, particularly in financial stocks.

The Fed's chances of going to NIRP seem, at least now, to be slim. Its policymaking arm, the Federal Open Market Committee, just hiked its interest target in December for the first time in nine years, so changing now would seem like a stunning retreat.

Yet several high-ranking officials recently have paid at least lip service to the idea.

In a speech last week, Fed Vice Chair Stanley Fischer said Europe's experiment with negative rates is "working better than I expected," raising speculation that should things deteriorate the U.S. central bank would consider going negative.

Negative rates in the U.S. would begin with the interest paid on excess reserves that banks store at the Fed, a number currently at $2.15 trillion that earns 0.5 percent interest. The idea would be to charge banks to store reserves, making the cost prohibitive to let the money lie fallow there and push it into the broader economy through lending, thus stimulating growth.

It's an idea that works in theory and, for a period, worked in practice for the four European governments that tried it. However, there are problems.

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One is that banks would need to make up that lost revenue someplace and instead of lending could amp up fees and rates. Another is that the more countries that join in, the less effective one nation's low or negative interest rates are.

Finally, in a problem that would be especially acute in the U.S., negative rates could send a jolt through the $2.75 trillion money market space and, some fear, lead to a "break the buck" scenario that occurred during the financial crisis when one large money market fund couldn't return par on its investments.

"Things would have to get truly desperate to go to negative rates," Kim Rupert, managing director of global fixed income at Action Economics, said in an interview. "Our money markets are obviously the biggest in the world and have a lot of commitments tied to them and the liquidity for a lot of our economy. Jeopardizing the money markets would be too dramatic an effect for the Fed to consider going in that direction."

Still, the futures market is indicating that if the Fed doesn't move to outright NIRP, the chances for an aggressive rate-hiking policy ahead, as indicated after the December rate rise, are nil.

The CME's FedWatch tool briefly went into a kind of backwardation Monday, indicating a -2 percent chance for a rate hike at the March FOMC meeting (the probability quickly moved back to plus 2 percent). The tool's farthest date, February 2017, indicates just a 15 percent chance of an increase, the implication being no moves in 2016 even though the Fed's "dot plot" of official projections points to four hikes this year.

The actual fed fund futures curve does not indicate a rate rise fully priced in until December 2017.

Michael Darda, chief economist and market strategist at MKM Partners, thinks the Fed would be wise to heed market signals and pay less attention to its models, including the Phillips curve guideline, that indicate a faster tightening cycle. The Fed's moves to end ZIRP and quantitative easing, along with China's decision to peg the yuan to the dollar, "has translated into a tightening world monetary policy" similar to what happened in the 1930s.

"The current risk is that policymakers are overly optimistic about the business cycle carrying on in a way that allows inflation to return to its target," Darda said in a note to clients. "Given the U.S. dollar's reserve currency status and the PBOC's quasi peg, global monetary conditions have tightened sharply, causing world nominal growth expectations to weaken. There are some disturbing parallels to 1937, in our view, that should continue to be monitored closely."

What the Fed will need to weigh ultimately is whether going to NIRP is worth risking its credibility, and whether low or negative rates will have any discernible effect on financial conditions. Bank stocks already are in a bear market, the economy is slowing and damage from the energy sector clearly is seeping into other parts of the economy.

Moving to NIRP now might be regarded as a panic reaction that actually could make things worse.

"I don't think there are high odds that we're going to fall into a recession this year, but what if we did?" said Jim Paulsen chief investment strategist at Wells Capital Management.

"If we went into recession now, when you had a zero short rate effectively and a sub-2 percent 10-year Treasury and a $4 trillion Fed balance sheet to spin out and a debt-to-GDP ratio that's 100 percent on sovereign government debt, I think there would be a fair amount of panic in the cultural mindset because there would be a sense that we went into recession and there's nothing anyone could do about it," he added. "That's a dangerous situation to put yourself in."