Thursday , 29 September 2016


Ben Bernanke On the Pros & Cons of Negative Interest Rates

…We can’t rule out the possibility that, at some point in the next few bernankeyears, our economy will slow, perhaps significantly. How would the Federal Reserve respond? What tools remain in the monetary toolbox? In this and a subsequent post, I discuss some policy options the Fed might consider, focusing first on negative interest rates.

By Ben Bernanke

First steps for easing policy

…Given where we are today, how would the Fed respond to a hypothetical economic slowdown?

  1. Presumably the central bank’s first response, after dropping any plans to raise rates further, would be to cut short-term interest rates, perhaps to zero.
    • Unfortunately, with the fed funds rate (the Fed’s target short-term rate) now between ¼ and ½ percent, and likely to remain relatively low, moving to zero provides much less firepower than in the past…
  2. With the fed funds rate near zero, the FOMC could next turn to forward guidance, that is, to communicating to markets and the public about the Fed’s policy plans.
    • If the Fed can convince market participants that short-term rates will stay low for some time, it can “talk down” longer-term rates, such as mortgage rates, which are typically more important to consumers, businesses, and investors…The evidence suggests that forward guidance can be quite powerful, and if the amount of extra policy support needed is not too great.
  3. The rate cuts plus guidance might be all that is needed but what if not? The Fed could resume quantitative easing (QE), that is, purchases of assets (typically longer-term assets) for the Fed’s portfolio, financed by the creation of reserves in the banking system.
    • Like forward guidance, the goal of QE is to reduce longer-term interest rates to encourage borrowing and spending. It appears to work through at least two channels.
      • First, the Fed’s purchases push up the price and (equivalently) push down the yield of the assets it buys. That effect is transmitted through the system as investors who sold the assets shift into others (such as stocks or corporate bonds).
      • Second, the Fed’s asset purchases can help signal its intention to keep rates low for a long time…[but] the FOMC might be reluctant to turn to it again.
        • It’s hard to calibrate, and communicating about it is difficult (as we learned in 2013 when Fed talk about ending QE led to a “taper tantrum” in financial markets).
        • It’s also possible that a new round might be less helpful than before.

…[Given the above,], the Fed might want to consider other options. Negative interest rates are one possibility.

Negative interest rates: general considerations

In practice, this means that, instead of receiving interest on the reserves they hold with the central bank, banks are charged a fee on reserves above a threshold. The expectation is that, to avoid the fee, banks will shift to other short-term assets, which drives down the yields on those assets as well, possibly to negative levels.

  • Ultimately, the efforts of banks and other investors to avoid negative returns on the shortest-term assets should lead to declines in a broad range of longer-term interest rates, such as mortgage rates and the yields on corporate bonds (though, generally, we’d expect these longer-term rates to remain positive, because of the extra compensation that investors demand for bearing credit risk and for tying up their money for longer periods).
  • By putting downward pressure on the interest rates most relevant to borrowing and spending decisions, the introduction of negative interest rates should work through the same channels as more standard monetary policies.

The idea of negative interest rates strikes many people as odd. Economists are less put off by it, perhaps because they are used to dealing with “real” (or inflation-adjusted) interest rates, which are often negative. Since the real interest rate is the sticker-price (nominal) interest rate minus inflation, it’s negative whenever inflation exceeds the nominal rate.

Figure 1 [below] shows the real fed funds rate from 1954 to the present, with gray bars marking recessions. As you can see, the real fed funds rate has been negative fairly often, including most of the period since 2009 – it reached a low of -3.8% in September 2011. Many of these negative spells occurred during periods of recession; this is no accident, since during recessions the Fed typically lowers interest rates, both real and nominal, in an effort to spur recovery.

negative interest rates

For most of the period reflected in Figure 1, the Fed had no need to implement a negative interest rate in order to ease policy:

  • Until 2008, the nominal fed funds rate was always well above zero, so that ordinary interest rate cuts remained feasible when needed.
  • Since late 2008, however, the fed funds rate has been barely above zero much of the time, so that achieving further reductions in the real funds rate would have required taking the nominal rate negative.
    • In principle at least, how much extra pop could this policy have delivered? If during this period the Fed had decided (and been able) to lower the short-term nominal interest rate to, say, -0.5%, then it presumably could have achieved a real fed funds rate half a percentage point lower as well.
    • For example, instead of being -3.8% in September 2011, the real fed funds rate might have been around -4.3%, with commensurate declines in other interest rates. As you can see, the amount of extra stimulus generated by this further reduction in rates would not have been negligible by any means (roughly, it would have corresponded to two extra quarter-point rate cuts in more normal times), but neither would it likely have been a game-changer…

How negative?

The fundamental economic constraint on how negative interest rates can go is that, beyond a certain point, people will just choose to hold currency, which pays zero interest. It’s not convenient or safe for most people to hold large amounts of currency, but at a sufficiently negative interest rate, banks or other institutions could profit from holding cash, for a fee, on behalf of customers.

  • Based on calculations of how much it would cost banks to store large quantities of currency in their vaults, the Fed staff concluded in 2010 that the interest rate paid on bank reserves in the U.S. could not practically be brought lower than about -0.35%.
  • Moreover, for various reasons, the 0.35 percentage points would not be fully reflected as declines in other short-term and longer-term rates…[and, as such,] concluded that the monetary policy benefit of a negative rate would likely be small.
  • Since 2010, however, several countries have implemented negative policy rates below the putative limit of -0.35% without triggering massive currency hoarding. For example, Switzerland’s policy rate is now at -0.75 percent, Sweden’s at -0.50 percent.
  • [In addition,] negative rates have even spread to longer-term securities; in Germany, government debt carries a negative rate out to maturities of eight years.

The lack of currency hoarding in Europe is intriguing and suggests that the negative rates tool might be more powerful than thought. I’m skeptical, though, that U.S. rates could go as negative as in Switzerland or Sweden, at least not without causing significant disruptions to the functioning of some key financial markets and institutions [as discussed at length in the unedited ([ ]) or abridged (…)  original article]. A general conundrum is that central banks need market participants to believe negative rates will be in place for a long time for there to be much effect on economically important long-term rates…If market participants believe that, they’ll have even more incentive to buy vault space and pay the other costs involved in hoarding cash….

[For the effect of negative interest rates on:

  • money market funds
  • banks and their profits and
  • some financial markets

please refer to the original article which first appeared on the Brookings Institution site on March 18.]

Conclusion on negative interest rates

The anxiety about negative interest rates seen recently in the media and in markets seems to me to be overdone.

  • Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate.
  • Moreover, a negative interest rate on bank reserves does not imply that the most economically relevant rates, like mortgage rates or corporate borrowing rates, would be negative; in the US, they almost certainly would not be.
  • Negative rates have some costs, in their effects on money market funds for example, but these ought to be manageable.
  • On the other hand, the potential benefits of negative rates are limited, because rates that are too negative would trigger hoarding of currency.

Although the European experience suggests that rates can be more negative than the Fed staff estimated in 2010, I don’t think U.S. rates could approach the extreme values seen in Switzerland or Sweden without becoming counterproductive.

Overall, as a tool of monetary policy, negative interest rates appear to have both modest benefits and manageable costs; and I assess the probability that this tool will be used in the U.S. as quite low for the foreseeable future. Nevertheless, it would probably be worthwhile for the Fed to conduct further analysis of this option.

We can imagine a hypothetical future situation in which the Fed has cut the fed funds rate to zero and used forward guidance to try to talk down longer-term interest rates…[yet] some additional accommodation is desired, but not enough to justify a new round of quantitative easing, with all its difficulties of calibration and communication. In that scenario, a policy of modestly negative interest rates might be a reasonable compromise between no action and rolling out the big QE gun.

By Ben Bernanke (brookings.edu/blogs/ben-bernanke/posts/) – The original article was edited ([ ]) and abridged (…) to provide a fast and easy read.
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