This crisis has broken a lot of economic taboos, with central banks buying up assets and expanding their balance sheets in a desperate effort to reflate a debt-laden private sector. The goal is to maintain economic growth, even at the risk of releveraging within the private sector to make up for a loss of private income-based demand. I think things can go a lot further.
For the time being, ideas like debt forgiveness and fostering increased savings rates to reduce private sector debt burdens are off the table. The emphasis now in policy circles is reflation. And that means higher asset prices to minimize the impact of deleveraging in the hopes that income-based demand can replace credit-based demand as a driver of the economy as the Fed’s reflation buys time. My view is that this policy effort will be unsuccessful. The best case scenario is a modest deleveraging, coupled with a modest rise in income-based private demand that is enough to keep the US economy growing at 2% in real terms, 4% in nominal terms.
However, I believe the likely outcome is less benign because the psychology of the balance sheet recession has taken hold to dampen both credit-based and income-based demand in the United States. Unless, fiscal policy, capital spending and trade can make up for this precautionary inertia, the US is in jeopardy of falling into recession due to an exogenous shock – like the fiscal cliff.
Let’s imagine a scenario in which credit and income-based demand increase real growth by a 1% annualized rate when the fiscal cliff hits and sucks 1 1/2% of annualized GDP out of the economy. That would mean recession, which would mean higher unemployment, lower asset prices, debt distress and a negative feedback loop of destabilizing proportions.
What would the Federal Reserve do in this instance? It has already communicated a zero rate policy that will remain accommodative even after the economy has improved. And it has resumed large scale asset purchases, targeting mortgage bonds instead of treasuries. Some are talking about nominal GDP targeting, and this idea seems to be catching on as Michael Woodford, an influential economist at Columbia University, voiced support for such an experiment in a recent speech at Jackson Hole.
I have long postulated that the Fed could target short-term municipal bonds when the economy turns down enough because it has authority to do so without prior congressional approval. Clearly, the muni market would be hit hard by another recession given all of the difficulties many municipalities are already having with tax revenue and pension liabilities. Helping the largest and most liquid state and local government issuers through a soft patch by buying short-term debt might be a necessity if a panic ensues that shuts these governments out of debt markets as the situation in Spain has done.
Another possibility that no one is talking about is negative nominal interest rates. Back in 2010, Eric Tymoigne wrote a very good post demonstrating that the zero lower bound is fictional and that negative nominal rates were, in fact, a possibility.
Could the Federal Reserve set the nominal federal funds rate and the nominal discount rate in negative territory?
Yes.
The discount rate is the most straightforward to grasp: the Board of Governor has perfect control over the discount rate and can set it wherever it wants whenever it wants. There is no operational constraint that prevents the Board from setting a discount rate at -1%, -10% or even -100%, it just needs to announce tomorrow that this is what it is and that is it.
The federal funds rate is slightly more complicated but not that much. To set a negative fed fund rate, the Fed just has to do overnight repos on securities at a premium. If one applies this to zero-coupon securities like T-bills, the present value of a T-bill is:
P = F/(1 + d)t
P is the present value, F is the face value, d is the discount factor, and t is time to maturity (let’s set t = 1 to simplify). Usually, d is positive meaning that the Fed buys T-bills at $90 and bankers agree to buy back the next day at $95 (d = 5%). Currently, for practical purposes one can assume that d = 0%, i.e. if bankers want reserves from the Fed, they sell T-bills at $90 and promise to buy them back at $90 the next day. To set d negative, the only thing the Fed has to do is to buy at $95 and resell at $90; stated differently, the Fed just has to agree to accept T-bills as collateral at a value of $95 and bankers have to agree to buy them back at $90 the next day. In this case the federal funds rate target will be negative 5%: 90/95 – 1. If the Fed performs enough of these kinds of operations, the federal funds rate will reach the -5% target.
So there is no operational constraint on setting negative nominal interest rates.
Once one passes this first hurdle a second question that usually comes is: is it “moral,” or does it make sense, to get paid by the person who lent you money?
First, negative interest rates on borrowed money are not new. Take checking accounts, for decades you and I have been willing to deposit our funds at a bank while earning 0% and paying a fee to maintain our checking account. This still applies today if you do not maintain a certain amount of funds in your account. The same has been going on T-bills and T-bonds. For example, “from mid-1932 through mid-1942, the vast majority of coupon-bearing U.S. government securities bore negative nominal yields as they neared maturity” (Cechetti 1988: 1112). The bid price of newly issued short-term US Treasuries slightly exceeded par during some weeks in the 1930s and the 1940s (Board of Governors of the Federal Reserve System 1943: 460, 462; Clouse et al. 2000), which resulted in very small negative yields (averaging -0.05% (Cechetti 1988)). Similarly, Treasury bonds with less than a year to maturity reached a magnitude as low as -1.7%. More recently, Japanese short-term treasuries had a slightly negative yield in 1998. It also happened in 2001 and 2003 (repos) and again in 2008 (T-bills) in the US (e.g. Fleming and Garbade 2004). Those peculiar cases can all be explained relatively simply by technical aspects specific to those securities and/or the circumstances of the moment. And those rates would have gone more negative if the overnight inter-bank lending rate had been set negative.
Second, currently the Fed is advancing reserves at 0-0.25% and paying 0.25% on reserves, effectively having a negative carry on its reserve account. That’s negative interest rate by another name right there: banks can borrow reserves at a lower rate than what they get paid to hold them.
Third, does it make sense to set a negative interest rate? What makes sense is what satisfies the needs and financial considerations of borrowers and lenders. Does it make sense for you and I to pay a fee on our checking account even though the reward is negative (0% – fee) ? Yes it does because of the convenience of having a checking account. Did it make sense for financial market participants to agree on negative interest rates on T-bills and T-bonds? Yes it did given the considerations at the time. So IF the Federal Reserve thinks that it makes sense to set its policy rates in negative territory, it can do it. Not tomorrow, not with the help of others; now, and at its discretion. And it could do so not by injecting any excess reserves, but just by operating in a way it has been operating since 1914 as explained previously here.
If the Fed went negative on nominal rates, it could say it was targeting nominal GDP, higher inflation rates or mortgage rates or whatever it wanted. The point is that the Fed would suddenly be a rate/price targeting entity again and the failed policy of quantity targeting would be at an end. The right question is what this kind of financial repression would do to the economy. Certainly, the Fed’s machinations would cause other interest rates to ratchet down as well, and the possibility of negative nominal rates in the private sector would suddenly become real – paying companies to borrow money.
My view is that this is a very dangerous policy option because it is inherently deflationary. The Fed can legitimately force negative rates in the market for reserves because it is the monopoly supplier of those reserves. As such, it can target whatever rate it deems appropriate, whether positive or negative. But negative nominal rates encourage investors to hoard cash as a higher-yielding substitute to financial assets. A shortage of credit supply and a reduction in the so-called money multiplier would be a distinct possibility. Why should I supply credit to the government or anyone else when I could simply hold cash as a riskless asset? I don’t see how this could be anything but a deflationary accelerator, causing inflation to drop as hoarding increased.
Bottom line: negative nominal rates are a natural extension of the Fed’s present permanent zero rate interest policy. If zero is not easy enough, under current thinking negative nominal rates are a possibility. But just as zero rates have reduced interest income and reduced the risk of holding cash, cash equivalents and non-yielding alternative assets instead of interest bearing ones, negative nominal rates would make this situation worse. I cannot discount them as a policy choice because the logic of zero rates can be applied equally to negative nominal rates in a deteriorating real economy. If the Fed has to contend with the fiscal cliff, negative nominal rates have to be considered one of many policy options it would explore. Just think of the effect on asset prices!