The next recession could force the Fed to do something nearly unprecedented. Here's what it is, and how it could impact you.
The San Francisco Federal Reserve recently published a paper showing that an unprecedented policy step, if adopted, would have helped the economy recover more quickly from the last financial crisis. With the next recession looming, one prominent Wall Street strategist thinks the unpopular tool will be necessary to combat it. The Federal Reserve's extraordinary efforts to combat the Great Recession more than a decade ago raised many concerns about what tools it will have left to fight the next crisis. One measure that was floated, but largely passed off as improbable, was the use of negative interest rates. The Fed had already done the unusual and held its Fed funds rate — the benchmark for all other borrowing costs — near zero from 2009 through the end of 2015. This made it sufficiently cheaper for companies and consumers to access credit and rebuild the battered economy. However, anything below zero was once considered unthinkable. After all, a negative interest rate means that, for example, savers theoretically pay banks to hold their money instead of earning interest. The mainstream discussion on negative rates has quieted down for a while since Sweden became the first country to cut rates below zero in 2015. However, a recent paper from the San Francisco Fed, coupled with widespread concerns about an economic slowdown, are returning the concept to the forefront. Vasco Cúrdia, the research advisor who penned the paper, examined what would have happened if the Fed went as far as adopting a negative interest-rate policy during the last recession. "Allowing the federal funds rate to drop below zero may have reduced the depth of the recession and enabled the economy to return more quickly to its full potential," he said. He continued: "It also may have allowed inflation to rise faster toward the Fed’s 2% target. In other words, negative interest rates may be a useful tool to promote the Fed’s dual mandate." This is not a policy option that Fed Chair Jerome Powell has talked about a lot, considering that the Fed was in hiking mode until very recently. When rates were lower, however, former chair Janet Yellen suggested the Fed would consider it after looking into "a wide range of issues." One market expert is already going as far as predicting that the Fed will cut rates into negative territory when the next recession comes around. Read more: The world's most accurate economic forecaster shares the major risk he views differently from most experts — and how investors can profit from it Albert Edwards, a strategist at Societe Generale and a steadfast market bear, has long thrown around this idea. He reiterated it to clients after reading the San Francisco Fed's paper. "I am more convinced than ever that we will see negative Fed Funds," Edwards said in a note on Thursday. He also predicts that the core consumer price index — a gauge of inflation that excludes volatile food and energy costs — will turn negative in the US and Eurozone during the next economic crisis. The good news so far about negative rates, according to the San Francisco Fed's Cúrdia, is that there has been no obvious negative effect on the financial stability of countries like Switzerland where negative rates have been used. Things could look a lot different for investors if negative US rates come anywhere close to being a reality. Specifically, negative rates would squeeze bank margins since they normally profit from the difference between the higher yield they earn on deposits and the lower interest rates they pay customers. If there's a credit crunch in the next recession, expect it to be worsened by the stress on bank margins. According to Edwards, this very concern is why many of his clients reject the notion that the Fed will seriously consider negative rates. But as the Great Recession and several years of zero interest rates taught us, never say never. SEE ALSO: A $2 trillion strategist is bracing for 3 years of pain for stocks. Here's how she says investors can fight back and keep squeezing out returns. Join the conversation about this story » NOW WATCH: Meet the three women who married Donald Trump