To zero..and beyond...

Day before yesterday, the Fed announced that is was cutting the Fed Funds rate close to zero. In the weeks preceding, the three-month US treasury bill rate has flirted with negative yields... Both phenomena raise a question: Can nominal interest rates become negative?

Let us start off by accepting the fact that real interest rates can become negative and have, for extended periods in the past. Real interest rates can happen when expected inflation is high but central banks decide to flood the market with enough funds to keep nominal interest rates below the expected inflation rate. However, a negative nominal interest rate is not only unusual but difficult to grapple with. As my sixteen-year old put it, why would someone put their money into an investment to get less in three months than they invest today? Why not stick the money in a checking account or even under the mattress for that period?

For small amounts of money, nominal interest rates should never fall below zero, because either the checking account option and the mattress option is viable. But what if you are a portfolio manager or a corporation with $ 3 billion in cash? Holding the cash balance as currency in your corporate headquarters is an invitation for the heist of the century (Think Oceans 11, 12 or 13..) Putting the cash into a bank account is not completely secure, because the FDIC protection works only up to $250,000.... If the bank goes under, your principal is at risk. In normal times, we would not consider this a likely scenario but we are not in normal times.

Both the Fed move to cut the Fed funds rate close to zero and the short term treasury bill rate dropping below zero are indications of how much investors have lost faith in the banking system. Large investors are in effect saying that they would rather accept an -0.5% nominal interest rate than risk leaving large amounts of cash in a bank. That is not only astounding but scary.