“No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays zero nominal interest.”– Ben Bernanke, 2009
“I think negative rates are something the Fed will and probably should consider if the situation arises.”-– Ben Bernanke, December 2015
“In theory there is no difference between theory and practice. In practice there is.”– Yogi Berra
Economists used to think below-zero interest rates were impossible. Necessity (as central banks see it) is the mother of invention, though; and multiple central banks now think negative rates are a necessary step to restore growth.
Are they right? Will negative rates pull the global economy out of its funk? Probably not; but for better or worse, several central banks are already below zero. The Federal Reserve just sent its clearest signal yet that it is headed that way, too. The Fed has warned banks to get ready. We had all better do the same.
This week’s letter has two parts. The first deals with some of the practical aspects of negative rates and what the Fed is really signaling. The second part, which is somewhat philosophical, deals with why the Fed will institute negative rates during the next recession. This letter is longer than usual, but I think it’s important to understand why we will see negative rates in the world’s reserve currency (and the currency in which most global trade is conducted). This policy trend is truly a foray into unexplored territory.
Be Careful What You Wish For
The idea of negative rates isn’t new; what’s new is the willingness to try them out. The Ben Bernanke quote above comes from a November 2, 2009,
Foreign Policy article in which the Fed chairman wrestled with how to keep inflation at the “right” level in a weak economy.
Set aside the question of whether there is any “right” level of inflation. As of six years ago, the head of the world’s most important central bank thought no one would ever lend at a negative interest rate. We now know he was wrong, at least with regard to Japan and most of Europe. Central banks there have instituted negative rate policies, and people are still borrowing and lending.
The Fed staff has also speculated on the possibility. Earlier this month my good friend David Kotok sent around links to several academic and central bank negative-rate studies. One was a 2012 article by Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York. Their title tells you what they thought at the time:
“If Interest Rates Go Negative… Or, Be Careful What You Wish For.”
Their point was less about the theoretical wisdom of NIRP and more about the actual potential consequences. They believed we would see a variety of odd responses to a very odd policy situation. All kinds of incentives would reverse, for starters.
Under negative deposit rates, buyers would want to pay their invoices as soon as possible, while sellers would want to delay receiving cash as long as possible. Think about your credit card bill. If you normally spend $10,000 a month, your best move would be to send the bank that much money before you spend it, then draw down the resulting credit balance. The bank would no doubt try to discourage this practice. Could they? We don’t know.
Garbade and McAndrews throw out another interesting idea: special-purpose banks:
If rates go negative, we should expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower than that.
Ludwig von Mises fans will recognize that this approach is not far from the Austrian economics goal of 100% reserve banking. It isn’t quite there because the vault contains fiat currency instead of gold, but I think Mises would recognize it as a step in the right direction. (The fact that Fed economists see it only as an exotic theoretical possibility wouldn’t surprise him, either.)
The consequences of such banking would be more than theoretical. If enough people wanted to use these special-purpose banks, demand for physical cash would go through the roof. There simply wouldn’t be enough to go around if it just sat in vaults instead of circulating. Furthermore, if the vaulted cash in these banks reduced deposits in normal loan-making banks, the whole banking system might grind to a halt.
That being the case, I suspect the Fed would prohibit banks from operating this way – but they can’t stop people from hoarding cash under their mattresses. The one thing they could do is eliminate physical cash. Denmark, Sweden, and Norway are already considering ways to do so.
Even more ominously, Bloomberg reported on. Feb. 9 that a move is afoot for the European Central Bank to get rid of 500-euro notes, the Eurozone’s largest-denomination bills. They portray this move mainly as a crime-fighting measure, but it would clearly make cash hoarding much more difficult.
And if Larry Summers and a few other well-known economists like Ken Rogoff have their way, we will see the demise of the $100 bill in the US. You thought you were just carrying those Ben Franklins around for convenience, not realizing that they make you a potential drug dealer in some people’s eyes.
And of course, hoarding cash would undermine the Fed’s goal of fighting deflation. Holding cash is by definition deflationary.
If Crazy Doesn’t Work, Try Crazier
All of the above is just speculation at the moment. We don’t know how deeply negative rates would have to go before people change their behavior. So far the negative rates in Europe and Japan apply mainly to interbank transactions, not to individual depositors or borrowers. Unless of course you are buying government bonds.
That said, we’ve seen a clear tendency on the part of central banks since 2008: if a crazy policy doesn’t produce the desired results, make it even crazier. I believe Yellen, Draghi, Kuroda, and all the others will push rates deep below zero if they see no better alternatives. And my best guess is they won’t.
Turns out negative rates aren’t exactly new. My good friend David Zervos, chief market strategist for Jefferies & Co., sent out a note this week pointing out that many “real,” inflation-adjusted rates have actually been negative for years. Such rates have thus far not produced the kind of reflation that central banks want to see. David thinks the ECB and BOJ should push nominal rates down to -1%, launch new quantitative easing bond purchases of at least $200 billion per month, and commit to do even more if their economies don’t respond.
Is Zervos losing his mind? No, he actually makes a pretty good case for such a policy – if you buy into his economic theories, which I discuss in the second part of this letter. (Over My Shoulder subscribers can read Zervos’s note here.) It is painfully clear to most of us that what the central banks have done thus far has not worked. I have a hard time imagining that a major NIRP campaign will help, but I’ve been wrong before.
Former Minneapolis Fed President Narayana Kocherlakota, who was for years the FOMC uber-dove, says going negative would be “daring but appropriate.” He has a number of reasons for this stance. In a note last week, he said the federal government is missing a chance to borrow gobs of money at super-attractive interest rates.
Kocherlakota would like to see the Treasury issue as much paper as it takes to drive real rates back above zero. He would use the borrowed money to repair our rickety infrastructure and to stimulate the economy.
It is an appealing idea – in theory. In reality, I have no faith that our political class would spend the cash wisely. More likely, Washington politicians would collude to distribute the money to their cronies, who would build useless highways and bridges to nowhere. The taxpayers would end up stuck with more debt, and our infrastructure would be little better than it is now.
The fact that this is a “monumentally” bad idea doesn’t mean it will never happen. There’s an excellent chance it will happen. Yellen and the Fed are clearly looking in that direction.
Yellen & the Spirit of Prudent Planning
Yellen might face one small problem on the road to NIRP: no one is completely sure if the Fed has legal authority to enact such a policy. An Aug. 5, 2010, staff memo says that the law authorizing the Fed to pay interest on excess reserves may not give it authority to charge interest.
This potential snag is interesting for a couple of reasons. With last month’s release of this memo, we now know the Fed was actively considering NIRP less than a year after Bernanke himself said publicly that “no one will lend at a negative interest rate.” Meanwhile, some at the Fed were clearly examining the possibility.
What else was happening at the time? The bond-buying program we now call QE1 had just wrapped up in June 2010. The Fed launched QE2 in November 2010. This memo came about because the Fed realized it needed to do more and was considering options. QE2 apparently beat out NIRP as the crazy policy du jour.
The question of the legality of negative rates came up again in congressional testimony a couple of weeks ago. Rep. Patrick McHenry (R-NC) directly asked Yellen if the Fed had authority to impose negative interest rates. According to press reports, she skirted a definitive answer:
Leave A Comment