Can we stop interest-rates falling and going negative?

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by Shaun Richards

This week has seen a development I have long-expected and forecast. That is that the establishment will respond to the next economic slow down with negative interest-rates. The rationale for that is in one sense simple as in most places interest-rates never went back up again and if they did by not much, Only yesterday I looked at my own country the UK where in the decade or so since the credit crunch the Bank of England has raised interest-rates by a net 0.25%. Not much is it? Last time around the only reason it did not cut interest-rates even lower it was because it feared that the creaking IT systems of the UK banks could not take it. As it was some mortgages ( mostly with Cheltenham & Gloucester if I recall correctly) went below 0% and were dealt with via capital repayments to stop a HAL 9000 style moment.

Of course more than a few central banks continue to have negative interest-rates as we look at Denmark, the Euro area, Japan, Sweden and Switzerland. The ECB may pause this morning to mull whether it will get its deposit rate ( -0.4%) back even to zero as it note German factory orders some 7% lower than the previous year in December. This brings us to the driver of the current situation which is the economic slow down we have been following and indeed predicting via the decline in money supply growth. That remains as a slow down and has not yet signalled an overall recession but none the less it has produced quite a change.

The San Francisco Fed

It is far from a coincidence that the San Francisco Fed has produced a paper on negative interest-rates this week. After all the overall Federal Reserve has put up the white flag on interest-rate increases as we wait to hear what was discussed when Chair Powell had dinner with President Trump on Monday night.  Anyway the paper seems to open with a statement of regret.

Traditionally, it has been assumed that nominal interest rates cannot fall below zero, known as the “lower bound.” Ever since 2008, researchers have debated how much monetary policy was constrained by this lower bound and how much it affected economic outcomes. To work around this constraint, the Federal Reserve turned to unconventional monetary policy tools such as forward guidance and large-scale asset purchases.

Also an admission that QE was driven by the belief that interest-rates could not go below zero. I cannot be too churlish about that because there was a time when I did not think so either at least on a sustained basis although it was around 20 years ago and before the full impact of the Japanese lost decade! I do not know if one of the drivers of this thought was fear of what negative interest-rates would do to the US banks but history has seen a potential revision.

In this Economic Letter, I consider whether pushing rates below zero would have improved economic outcomes in the United States in the aftermath of the financial crisis.

For a central banker the answer is clearly yes.

Model estimates suggest that reducing the effective lower bound for the federal funds rate to –0.75% would have reduced economic slack by as much as one-half at the trough of the recession and sped up the ensuing recovery. While the boost to the economy would have been negligible after 2014, inflation would have been higher throughout the recovery by about half a percentage point on average.

There are various points here. First the central banker assumption that higher inflation is a good thing whereas in reality the ordinary person is likely to be worse off via lower real wages. Next the interesting observation that it is a temporary gain. Finally there is a later reference to Switzerland which took interest-rates to -0.75% so we are left with the view that this paper might recommend even more negative rates if only someone else had been brave/silly enough to try them. It omits to point out that Switzerland has not escaped from this as it is still at -0.75%.

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How does this work?

An old friend appears.

In the model, the output gap falls with the interest rate.

Ah so it works because we assume it will. What could go wrong? Whilst we are at the Outer Limits of fantasy why not throw in the kitchen sink.

However, expectations about the future path of the fed funds rate matter, including any Federal Reserve announcements about its path—known as forward guidance—as well as expectations about being at the zero lower bound.

I am not sure if that is chutzpah, ignorance or just simple Ivory Tower non-thinking. After all we have just had a Forward Guidance U-Turn so are we following the old or new versions and if so what was the cost of the change? Those who have fixed their mortgage expecting higher interest-rates for example. Whereas now Men at Work are being played.

It’s a mistake, it’s a mistake
It’s a mistake, it’s a mistake

Rather oddly the paper says that the output gap is pushed higher when the author must mean lower, But there is a bigger space oddity which is this.

According to these simulations, the negative lower bound would have reached its maximum effect in the first quarter of 2011. Setting the lower bound at –0.25% would have increased the output gap by 1.5 percentage points, while pushing the lower bound down further to –0.75% would have contributed an additional 0.4 percentage point to the output gap. This means that a rate of –0.25% would have done most of the job, and allowing it to drop further would have accomplished fewer additional benefits.

Let us subject that to a sense check because we know that the US Federal Reserve did cut its official interest-rate to 0% ( technically 0% to 0.25%) but that going a mere extra 0.25% would make much of a difference? From the previous peak the US had cut by 5% so would an extra 0.25% make any difference at all?

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The IMF goes further

Here we go.

One option to break through the zero lower bound would be to phase out cash.

It wants to go as Madonna would put it, deeper and deeper.

To illustrate, suppose your bank announced a negative 3 percent interest rate on your bank deposit of 100 dollars today.

They need a tax or fine or cash to achieve this.

Suppose also that the central bank announced that cash-dollars would now become a separate currency that would depreciate against e-dollars by 3 percent per year. The conversion rate of cash-dollars into e-dollars would hence change from 1 to 0.97 over the year.

Comment

There is quite a bit to consider here but let me start with the concept of arrogance. This is because monetary policymakers have had the freedom over the past decade to do pretty much what they liked and if it had worked we would not be here would we? Yet like Jose Mourinho in the football transfer market they always want more, more, more. Actually I am being a little unfair on Jose as there was a time his policies brought plenty of success.

Combined with this is an obsessive clinging onto failed past concepts. The output gap has had a dreadful credit crunch yet here it is again. Next the idea that higher inflation is good has ( thank God) had a bad run too but central bankers confuse what is good for the banks with what is good for the rest of us. The reality that no country or economic area has gone into negative interest-rates and then recovered is simply ignored whereas so far they have all sung along with Muse.

Glaciers melting in the dead of night
And the superstars sucked into the super massive
Super massive black hole
Super massive black hole
Super massive black hole
Finally is the idea that those who do not worship at this particular monetary altar need to be punished. Just like in the novel 1984……
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