Negative interest rates: some thoughts

I’ve been keeping an eye on the range of commentary and analysis appearing recently on negative policy interest rates –  options and limitations.  The issue has come back to prominence because of the BoJ’s recent modest move to introduce a negative policy rate, and amid the rising concerns about global growth and, perhaps, financial fragility that have been reflected in market prices –  equities, bonds, commodities, CDS spreads etc –  since the start of the year.

Doing something about removing, or markedly easing, the near-zero lower bound on nominal interest rates has been a cause of mine for some years.  While I was working for The Treasury in 2010 I wrote a discussion note, that got some circulation inside and outside the institution, concluding (somewhat to my own unease) that in some respects the world was less well placed than it had been in, say, 1930  – the early days of the Great Depression.   Back then, countries could get rid of the Gold Standard –  and eventually did so –  markedly easing monetary conditions in the process.  Having got nominal interest rates to around zero in much of the advanced world, there wasn’t a great deal else monetary policy could do if economies were to turn down again (or simply fail to recover).  Unsterilised fiscal policy (direct purchases of goods and services) might be an option on paper, but by then the tide had already turned against expansionary fiscal policy, and public debt levels in many countries were becoming worryingly (to the public, and conventional political wisdom) high.

The remaining option was to do something about the near-zero bound, which existed –  in a fiat money system –  only because of policy and legislative choices (typically, a state monopoly on currency issue, and a commitment to convert bank deposits into those state issued notes at a fixed one for one parity).   Why hold large proportions of one’s wealth at materially negative interest rates when –  once a few set up and holding costs were negotiated –  one could hold bank notes at a zero return?  (Some earlier thoughts on these issues are here and here)

No central bank had taken policy rates negative during the 2008/09 recession.  For some –  New Zealand was a good example –  there was simply no plausible need.  But in others –  the US and the UK appear to have been the prime examples –  it didn’t happen partly because the relevant authorities really weren’t sure about the implications would be.  Whole business models –  money market mutual funds, which had run into troubles in 2008 anyway –  had been built around the idea the interest rates don’t go negative.  And, at the time, it seemed to pretty much everyone that interest rates would be extremely low for only quite a short period, so why risk creating a mess, disrupting well-established business models, for a small short-period additional kick.

As we know, interest rates have now been very low for a very long time.  Some argue that wasn’t necessary, or wasn’t desirable, but whether one focused on an inflation target, on the level or growth of nominal GDP, or even economywide credit, it is difficult to conclude that interest rates in most countries should have been any higher in the last few years than they have been.  One could, in fact, mount a good argument that they (a) should have been lower, and (b) would have been lower if the technological/regulatory bound had not been there.   If, for example, inflation targets in the previous 20 years had been 4 per cent, not 2 per cent, I think there is little real doubt that real interest rates would have been lowered further.

In the last few months of Alan Bollard’s time as Governor of the Reserve Bank of New Zealand –  when yet another wave of the ongoing euro-area crisis was upon us –  I led an internal working group looking at some of our options if there were to be a new global crisis and a material downturn in New Zealand.  We concluded that in our relatively simple system there were few or no obstacles to taking the OCR negative should that be needed –  there was, for example, nothing like the money market mutual fund sector to trouble us.  We didn’t reach a firm view on how far the OCR could be cut before banks and other investors might turn to physical cash instead, but it seemed reasonable that we would have been able to cut to perhaps -50 or -75 basis points.  With a few suggestions to check that our technology could handle negative interest rates, we put the report aside as that wave of tensions eased.  Negative interest rates have not yet been needed in New Zealand.

What we didn’t do was to explore how to get around the floor that would inevitably be there at some point. I guess it wasn’t a high priority for the Reserve Bank of New Zealand –  with policy rates among the highest in the world, we were further from the floor (whatever it was) than most countries.  And –  always a comfort  – if our interest rates ever did get to zero (or negative) it seemed likely that the New Zealand exchange rate would be very weak.  We aren’t a surplus country, or any sort of serious “safe haven”, and if there are no yield advantages to holding NZD assets, in most circumstances there won’t be much foreign demand to hold them.

But as far one can tell, no one else in the senior levels of officialdom  anywhere else was doing very much about it either.  One can –  and should – bemoan the lack of contingency planning, but it probably just reflects the same mistake that has been made around the world since the crisis and downturn started to get underway in 2007.  There was a reluctance to recognise what was coming[1], a slowness to react even as the crisis was open us, and once the immediate worst of the crisis was over the constant relentless focus has been on “normalisation”.  And it wasn’t just central bankers… economists and participants were often just as focused on the tightenings that, it was confidently assumed, were to come.  It was the path that led various central banks into premature tightenings and then policy reversals  –  New Zealand leading the way, with two lots of reversals.  And it hasn’t just been about small central banks, or big ones –  pretty much everyone has shared in the delusion that it wouldn’t be long until we were well on the way back to “normal” –  real interest rates perhaps not much lower than they had been on average in, say, the decade prior to 2007.   The US Federal Reserve has often been as fallible as anyone, and it seems increasingly likely that its own “normalisation” programme might be brought to an end, and reversed, after just one tightening.

It all means that dealing with the zero lower bound doesn’t seem to have been treated very seriously by central banks and finance ministries.   We now have several advanced economies –  covering a large chunk of the advanced world’s economies –  with negative policy rates, but in each case it still comes with the question “how far can they go”, and in each case so far the move to negative rates has been less than whole-hearted. Central banks look and sound as though they are backed into it very reluctantly, rather than embracing enthusiastically what needs to be done.

Negative rates have been applied to only a portion of banks’ balances at the central banks –  structured, it seemed, to have as little impact as possible on banks and their customers.  There has been a logic to that –  the focus in many of these countries was on the exchange rate channel, and the announcement effects of moves to adopt negative rates appear typically to have been to weaken the respective exchange rates.  But it hasn’t exactly been a ringing endorsement of the efficacy of negative policy rates.  It all seems to have been accompanied by a fear of upsetting established business models, and a fear that before too long the limits of negative rates will be reached.

JP Morgan has an interesting note out last week looking at how far various central banks could take policy rates negative, without imposing more of a “tax” on banks than is being imposed in the most negative central bank now.  They suggested that some central banks could take a (tiered) negative rate as low as perhaps -4 per cent.

But monetary policy isn’t supposed to work by imposing taxes on banks, but by influencing private sector behaviour through a variety of channels.  Substitution effects matter.  And so do expectations channel.

But if central bankers don’t believe that they can do much more, or that their tools won’t really have much impact –  or perhaps, in their heart of hearts don’t really want to do much more ( after all, surely we need to keep “normalisation” in mind) –   it is hardly surprising that people more generally (not just market participants) become nervous when new risks come to the fore (China, Portugal, Italian banks, stresses on commodity producers or whatever)   When there is no ringing endorsement from central banks for banks to pass negative rates decisively through to firms and households (savers and borrowers) no wonder banks are tentative in doing so.  And that central bank tentativeness further undermines the potential effectiveness of the tools they might still have.  We see that with global inflation expectations falling, so much that central banks are struggling to avoid rising real interest rates.

I’m reading Scott Sumner’s The Midas Paradox at present, a stimulating take on the Great Depression.  As he notes, in that climate for a country to devalue, or go off gold, was stimulatory.  But when markets feared a country might go off gold, even if it had no desire to do so, that was severely contractionary (people –  and institutions – ran to gold, rather than paper money, with a cumulative contractionary effect). There wasn’t a belief that central banks could credibly do much to offset that sort of tightening in conditions.   There aren’t direct parallels to today’s situation, but if people think that the monetary options are almost exhausted it amplifies the adverse impact of any emerging bad economic news

It is all unnecessary.  If central banks five or more years ago had put their minds to dealing with the zero bound, we’d be far better positioned today.  Authorities could say with conviction that there was no limit to how far policy rates could be cut.  Banks –  and savers/borrowers –  would be that much more attuned to the possibility of materially negative rates (nominal, not just real).  As people like Miles Kimball have pointed out, it doesn’t take the abolition of all physical currency – which continues to have real convenience value for many people/transactions.   And that is why it still is not too late to act.  Central banks could cap the issuance of their currency, and work with ministries of finance to enable variable conversion rates.  These are unfamiliar concepts to the public –  and would take some socialisation.  But every day that is lost in beginning work on these sorts of initiatives exposes the world economy to really serious threats if the current set of risks crystallise (or another lot do a little further down the track).

In having delayed so long, when central governments and governments do finally move it risks looking like a panic measure.  It isn’t clear how to avoid that now –  but the best chances to avoid that sense is in those countries that still have some conventional monetary leeway (New Zealand and Australia among the few).

And, of course, the other option that could have been pursued was a higher inflation target.  I’ve written about this previously, as have others.  I still regard it as less desirable than the alternative  – doing something directly about the near-zero bound. That is particularly so in countries that have already pretty much reached the limits –  if the central bank has no effective instruments why would anyone give much weight to an increase in an announced inflation target.  Again, the options are different for New Zealand and Australia.

Central banks and governments have delayed far too long already, and they now risk reaping a very nasty harvest –  or, more accurately, seeing it imposed on their populations.  It was when central banks and governments finally moved off the Gold Standard –  usually just as reluctantly as today’s central bankers are too fully embrace negative rates and/or higher inflation targets –  that economies finally began to sustainably recover from the Great Depression.  Today’s threats are a little different in the details, but there is a pressing need for markets, the public and politicians to come to believe with some conviction that inflation will return, and that authorities have the instruments to raise inflation effectively and without question.  Persistent doubts on that score  –  including doubts of self-belief among the central bankers –  only increase the risks of a very nasty global deflationary period over the next few years.  Cutting policy rates barely as fast as inflation expectations are dropping away isn’t a recipe for boosting demand –  or creating any sort of robust confidence that inflation targets will be met.   Central bankers barely believe they will. Why would anyone else?

[1] I recall a serving G20 Governor telling me at a conference in early 2008 that he couldn’t understand what the Fed thought it was up to cutting interest rates.  A few months earlier, at another international meeting, a senior Fed staffer told us that while the market was beginning to look for cuts, the Fed still thought the next Fed funds move was upwards.