Negative nominal interest rates

Late last week the New York Fed posted some interesting  and thoughtful speech notes by James McAndrews, their Director of Research, on “Negative Nominal Central Bank Policy Rates: Where is the Lower Bound” (see also some comments here from John Cochrane).

But McAndrews doesn’t really answer the question he poses, and instead offers a series of thoughts on some of the issues (institutional and policy) associated with negative nominal interest rates.   If it seems somewhat geeky it is, or should be, a pressing issue.  Four countries already have modestly negative policy interest rates for some balances.  Most other advanced countries have policy rates at or near zero and even in “high” interest rate Australasia the buffers are no longer large.

McAndrew outlines seven ”complications” with negative interest rates.  I won’t touch on them all –  read the speech.

The first, and best-known, is “avoidance”, the possibility of shifting into physical currency (which, at present, carries a zero nominal return).  He argues that currency is a less effective substitute for electronic money than many realise, and seems to put quite a lot of weight on the inconvenience of physical currency.  But that case seems a great deal stronger for mid-sized transactions than for the  store of value function of money.  I’m a trustee of a pension fund  and, to take an extreme example,  if nominal interest rates ever got to, say -10 per cent, I can’t envisage that I would have many qualms in agreeing to the bulk of the fund’s assets being held in secure (and insured) physical currency form, rather than interest-bearing securities as at present.  Yes, we would still need some electronic balances available to make our routine pension payments, but those transaction balances are small relative to the stock of assets.  In the same way that most of us still held zero-interest transactions balances in the high inflation era, we might still be quite comfortable to have, say, one week’s salary in an account earning a material negative interest rate simply because it is more convenient.  To settle wholesale payments, the transfer of claims over physical bank notes seems quite feasible (with time, and an expectation that interest rates would stay negative for a prolonged period).  The big risk central banks are concerned about is not that your cheque/EFTPOS account would be converted back into physical currency, but that banks and large investors would choose to convert their assets (where choices are heavily driven by relative expected returns).

Abolition of physical currency would, of course, eliminate this problem altogether.  I’m not in the camp of those who favour that option, and neither is McAndrews.  Indeed, I’m not sure that elimination of physical currency is even a legitimate call for a government to make.  As I outlined last week, I would rather go in the other direction, removing the government monopoly on banknotes[1], and allowing market competitive forces to get to work, including innovating smart ways to provide positive and negative returns on these nominal liabilities.  Central banks are monopoly providers, not known for their innovation and product development (an interesting OIA request might be to ask how many resources the RBNZ or RBA have devoted to product development and innovation in respect of physical currency, security features aside).  In time, whatever product innovation succeeded in the market could end up adopted by central banks themselves.  More immediately, central banks should be working on developing a retail electronic outside money product, which might in time displace physical central bank currency.  Banks have access to electronic outside money: why not the public?

In the shorter-term, abolition of physical currency is not even needed to provide material additional room for negative nominal interest rates.  A cap on total issuance, and allowing the conversion rate to fluctuate, would be enough to prevent wholesale conversion of electronic balances into physical currency.  It would be a significant step – two sets of central bank liabilities would have different values –  but not one that is either irrevocable, or particularly difficult to implement.

McAndrew also outlines various institutional frictions that might evolve differently if substantial negative nominal interest became more established.  For example, the ability to prepay tax obligations, or to delay depositing a cheque, could all represent ways to avoid a negative interest rate.  Frankly, most of these seem rather small issues, especially when weighed against the economic conditions that have led to negative interest rates becoming a realistic policy option.   Surely, for example, it would be easy enough for banks to alter their rules to require all cheques to be deposited more quickly than the current rules, perhaps especially those for large amounts?  And, if the US government has not already done so, the establishment of an interest rate (positive or negative) on prepaid taxes doesn’t appear that difficult.

I’m not going to go through each of McAndrews’ seven points, but will touch briefly on his two final ones.  He worries that establishing negative nominal interest rates might adversely influence public expectations of inflation, entrenching expectations of deflation.  Of course, anything is possible, but this seems very unlikely.  When policy rates around the world were slashed in 2008/09 that didn’t lead to a collapse in inflation expectations –  if anything there was unjustified degree of concern about future risks of high inflation.  In the end, decisive action to counter the risk of excessively low inflation (or deflation) seems much more likely to keep inflation expectations near target.   Indeed, one could that if the public realises that the limits of conventional monetary policy have largely been reached, then whenever the next downturn happens there is a more serious risk that inflation expectations will fall  much more rapidly than happened in 2008/09

His final point is about public acceptance.  Yes, negative nominal interest rates are a new phenomenon, and not one anyone has much familiarity with.  And no doubt central bankers, and politicians, would get many letters from aggrieved pensioners – just as happened when real and nominal rates fell over the 15-20 years prior to the recession. But the job central banks have taken on is one of macroeconomic stabilisation – stable inflation (or wages or nominal income) at as close to effective full employment as possible.  Big changes in relative prices (eg real interest rates) have distributional consequences.  Compensating losers is an option for governments and legislatures, but central banks need to keep a focus on cyclical macroeconomic stabilisation.  Yes, negative interest rates would be a communications challenge.   But prolonged high unemployment –  the risk if real interest rates can’t be cut enough –  is rather more serious than that.  Dealing with the unfamiliarity can’t be done fully until countries actually find themselves with negative interest rates, but central banks can make considerable progress –  especially in countries like New Zealand where negative rates are still some way away –  by starting early, preparing the ground and giving people a sense of what is at stake.

McAndrews ends this way:

Addressing the complications of negative nominal interest rates includes redesigning debt securities; in some cases, redesigning financial institutions; adopting new social conventions for the timeliness of repayment of debt and payment of taxes; and adapting existing financial institutions for the calculation and payment of interest, the transfer and valuation of debt securities, and many other operations. These innovations will require considerable time, resources, and effort. A benefit-cost analysis thus must weigh the potential advantages of negative rates against the costs of pushing back the tide of all of these conventions and institutions that have proven useful under positive nominal interest rates. That calculation likely will differ across countries, across institutional environments, and across the expected levels and duration of negative rates.

Much of that is fine, but it also reads rather complacently. In particular, it seems indifferent to the macroeconomic conditions that have given rise to discussions of this sort (and to negative nominal rates in several countries).    A common view, not universally shared but common, is that the US could usefully have had real short-term interest rates perhaps five percentage points lower than they were during the Great Recession of 2008/09  (in other words, given inflation expectations as they were, a negative nominal policy rate of perhaps -5 per cent).  The inability to do so meant, presumably, a material loss of output at the time, and a material number of people who spent time unemployed that would not otherwise have been necessary.  Those losses mount quite quickly.

Perhaps there is a strong public policy case for avoiding negative nominal policy interest rates.  I can’t see myself,  but if a consensus were to form on that side of the argument then, as I outlined a couple of weeks ago, there would be a strong case for a materially higher inflation target. Macro-stabilisation seems to require, at times, more deeply negative real interest rates than was generally appreciated when 2 per cent inflation targets were adopted.

But adopting higher inflation targets has its own institutional challenges and costs –  in particular, tax systems that are pervasively not designed to operate well with materially positive rates of inflation (and the non-payment of interest on physical currency).   And there is the practical problem that for most countries at present –  without the ability to take policy interest rates materially negative –  it is difficult to get inflation much higher than it is now.   It would seem preferable for finance ministries, legislatures, and central banks to now treat as a matter of some urgency the removal of as many as possible of the policy or regulatory roadblocks that limit the scope for materially negative policy interest rates before the next recession hits.

I have heard mention that Miles Kimball is visiting New Zealand shortly. If so, I hope the Treasury (and the RB) use the opportunity to explore options more seriously, and that the media take the opportunity to give the issue some more coverage.

[1] To repeat, this is NOT free banking.

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