[Viewpoint] The U.S. Economy Is Already in a Negative Interest Rate Situation

Kim Young-ik, Adjunct Professor at Sogang University Graduate School of Economics

In the United States, discussions about the possibility of negative (-) interest rates are actively taking place not only among economists but also among policymakers. Given the current economic situation, the appropriate level of the federal funds rate or market interest rates is already negative. It is a matter of timing, but such a phenomenon could manifest in the real economy.

First, let us examine the appropriate level of the federal funds rate, which is the policy rate of the Federal Reserve (Fed). The Taylor rule is commonly used to estimate the appropriate interest rate. This method finds the suitable interest rate by considering factors such as inflation rate and unemployment rate (or GDP gap rate). To apply the Taylor rule, one must first estimate the natural real rate and the natural unemployment rate. Most economists consider the natural interest rate in the U.S. to be around 2% and the natural unemployment rate about 5%.

Last month, the U.S. unemployment rate surged to 14.7%. The Fed sets its monetary policy goals as maximizing employment and stabilizing prices. When deciding the direction of monetary policy, the core personal consumption expenditures price index is regarded as the most important indicator, which is estimated to have risen by 1.5% last month. Plugging these figures into the Taylor rule, the appropriate level of the federal funds rate last month was negative 6.6%.

The problem lies in the expectation that the unemployment rate will rise further and inflation will decline more. Between March and April, nonfarm payroll jobs decreased by 21.37 million. In the previous ten years, jobs had increased by 22.74 million, meaning that the jobs gained over a decade vanished within two months. Even this month, new unemployment claims have remained very high at 6.16 million over two weeks. Goldman Sachs forecasts that the unemployment rate could rise to 25% during this recession phase.

Even if the economy recovers in the second half of the year, deflationary pressures exist in the U.S. economy, making it highly likely that inflation will decrease further. According to the Bloomberg consensus as of the 15th, the U.S. economic growth rate is expected to rise from -5.6% this year to 4.0% next year. However, because the shock from the novel coronavirus disease (COVID-19) is so severe, even if the economy recovers after the second half of this year, the actual GDP will remain significantly below potential levels. Comparing potential GDP and actual GDP estimated by the Congressional Budget Office, the GDP gap rate (percentage difference between actual and potential GDP) for Q2 this year is -10.8%, marking the worst recession since the U.S. GDP was officially recorded in 1947. Even if the economy grows by 4.0% as consensus suggests, the GDP gap rate is expected to remain below negative 4%. Because deflationary pressures exist in the economy, inflation must inevitably decline, and it is highly likely that the core personal consumption expenditures inflation rate will soon fall below 1%. This would lower the appropriate interest rate further, meaning that negative interest rates are possible both theoretically and practically.

For financial market participants, the bigger concern may be whether not only the benchmark interest rate but also market interest rates could fall into negative territory. Typically, the appropriate interest rate level is expressed as the sum of real economic growth and inflation rates, i.e., nominal economic growth. The representative indicator of market interest rates is the 10-year Treasury yield. Over the long term, this yield has maintained a level similar to nominal GDP growth. From Q1 1961 to Q1 this year, the average Treasury yield was 6.06%, and nominal economic growth was 6.45%. This year, nominal GDP growth is expected to be around negative 5%. This suggests that even if U.S. Treasury yields fall into negative territory, it would not be inconsistent with the economic situation.

Due to COVID-19, economic phenomena that we had never imagined before are occurring worldwide. Before the U.S. economy returns to normal, unprecedented events in history are likely to happen. One of these will be 'negative interest rates.'

This content was produced with the assistance of AI translation services.