The Fed could NIRP a downturn in the bud

When Ben Bernanke was steering the Federal Reserve (Fed) through the financial crisis, as chair between 2006 and 2014, he had two principal levers: quantitative easing (QE) and interest rates.

Although he demonstrated his willingness to think unconventionally and act radically by embracing QE, he appeared loath to take interest rates into uncharted territory. The Fed funds rate was thus set resolutely at 0-0.25% between late 2008 and December 2015, even as various iterations of QE were enacted.

Under Bernanke’s successor Janet Yellen, there was no active discussion of negative rates at the Federal Open Market Committee (FOMC) either, in this case because the focus was more on the timing and speed of interest-rate hikes and quantitative tightening.

A lower lower bound

But with the Fed pivoting back to a dovish stance, it may be worth revisiting the case for negative interest-rate policy (NIRP) in the US. One economist at the central bank, Vasco Curdia of the San Francisco Fed, has already broached the subject.

He wrote a paper in February arguing that negative interest rates would have delivered a faster recovery from the financial crisis and restored inflation to the target level much sooner, basing his model simulations on an effective zero lower bound of -0.75%.

The same author also advocated inflation overshooting in 2016, using very similar language to that subsequently adopted by his then-boss John Williams in a December 2018 speech. So it seems highly likely that if the circumstances arose, at least Williams – now a voting FOMC member as the Fed’s vice chairman – would be open to the idea of negative interest rates.

There are several reasons why the Fed may be more comfortable with negative interest rates now than it was during the last crisis:

• So far there have been no signs of serious adverse effects on financial stability in countries that used negative interest rates, most obviously in the euro area which seems to be on the brink of cutting rates to -0.5% or -0.6%.
• Negative rates appear to be effective in pushing down a broad range of longer-term interest rates, as banks and investors attempt to avoid the negative returns on the shortest-term assets.
• There is an even firmer belief around the need to drive real interest rates negative in a world where the neutral real interest rate is believed to have fallen further.
• The operational concerns, such as the software modifications for handling negative rates, are surmountable.

One more serious issue that arose under Bernanke was the Fed’s legal authority to impose a negative interest rate on reserves. The law is not clear on this matter and these legal hurdles would have to be resolved.

Back in 2010, the Fed also concluded that interest rates on reserves could not be brought below -0.35% as at these levels banks would switch to holding cash, for a fee, on behalf of their customers. The lack of currency hoarding witnessed in Switzerland (with rates at -0.75%) and Sweden (-0.5%) suggests the Fed was too cautious in its estimation on that front.

The Fed was more concerned about the impact on money market funds (MMFs) rather than bank profitability, as negative rates could have forced MMFs to shut down and so disrupted short-term funding for banks and non-financial firms. But changes to the rules since then mean that, under negative interest rates, MMFs could now return less than invested in them.

More broadly, there is little concern today about US banks’ profitability. Even if there were some hit to shareholders from a move to negative interest rates, it seems likely that banks would be able to pass on negative rates as the majority of their funding comes from wholesale funding markets and large institutional depositors rather than small depositors.

Finally, judging by his own writing, Bernanke himself seems keener on negative rates today than he once was! 

So, with Donald Trump using Twitter to call for more accommodative monetary policy in ever-greater numbers of capital letters, it is very much conceivable that in the next downturn the Fed might opt for modestly negative interest rates even before resuming QE.