Negative rates in US? Here’s why it could happen

Less than two months after the Fed enacted its first rate hike in more than nine years, market talk already has turned to whether the central bank’s future may not be more hikes, but rather negative rates.

Intensifying recession fears, volatile financial markets and moves toward negative rates by other central banks have triggered speculation over whether the Fed may have to reverse course on its tightening policy.

Negative rates in the U.S. would be a highly unusual move. However, several high-ranking Fed officials, including Chair Janet Yellen, Vice Chair Stanley Fischer and New York Fed President Bill Dudley all have indicated the move would be something they would have to examine should financial conditions tighten and threats to economic growth increase.

Read MoreGross: ‘Shades of 2007’ as central banks flunk

“While not our baseline scenario, if the U.S. economy were to sufficiently weaken we believe the Fed could consider negative rates as a means to ease policy,” Mark Cabana, rates strategist at Bank of America Merrill Lynch, said in a note to clients.

Cleveland Fed President Loretta Mester said Thursday she likely would not favor negative rates.

“As a policy maker, it’s incumbent on me to look seriously at it. But I’m still a little reluctant to there,” she said during a question-and-answer session in New York Thursday evening. “I think our financial system is quite complicated. I’m not sure what the effects will. I have a feeling it wouldn’t be that effective.”

Before making such a move, the Fed likely would consider a variety of alternatives: takings the funds level it uses to target interest rates back to zero, instituting “forward guidance,” or benchmarks it would need to see before hiking rates further, and again imploring Washington lawmakers to use fiscal policy to stimulate growth. The Fed also could choose to implement a fourth round of quantitative easing, the “money printing” program that has coincided with sharp gains in the stock market.

However, the temptation toward negative rates looms, despite mixed evidence that going to negative rates has a significant effect.

Read MoreCan the markets predict recessions?

The Bank of Japan stunned markets recently with its move toward negative rates, which already were in play around Europe. The Fed’s tightening while its global counterparts are easing has been a recurring worry for U.S. investors.

Instituting negative rates has a goal of shocking banks into lending and stimulating inflation, which has been in short supply both in the U.S. and much of the world’s developed markets.

One of the main instruments the Fed could use is on the interest paid on excess reserves. Banks have $2.34 trillion stored at the Fed compared to $99.7 billion required. The Fed pays 0.5 percent on those reserves, so reducing that number or pushing it below zero would be one way the Fed could get money moving again into the broader economy.

The Fed also could cut the rate on its overnight reverse repo operations, a move that effectively would lower the cost of money
[“source -pcworld”]