Great headline today from the Financial Times:
Fed study puts ideal US interest rate at -5% - Financial Times – April 27, 2009
The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve’s last policy meeting. The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation. A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.
It’s a silly attention grabbing headline, but it got me thinking about modeling rate floors. Anybody running an asset/liability model has no doubt adjusted their model to take into account rate floors. They’re most visible in the earnings simulation when modeling core deposit rates. Banks can’t pay much less than 10 or 20 basis points. Rate floors may also show-up in the bank’s loan portfolio - making their rates down earnings simulation behavior look more like a fixed-rate portfolio.
One place where I’ve seen rate floors noticeably absent is in the balance sheet (EVE) simulation. You should double-check that the discount rates used for your present value simulations don’t fall below zero. Take a look at the rate down shocks; increases in portfolio values should slow down noticeably as you get past the –100bp shock. Of course it depends on the type and base-case duration of the portfolio - it should be much more noticeable on your shorter-term portfolios.