Money for less-than-nothing, credit for cheap.
Donald Trump is not known for the keenness of his macroeconomic insights. Throughout his time in office, the president has simultaneously insisted that he is an expert in global trade and that a tariff is a tax that foreign governments pay to the United States in order to sell their goods on the American market.
So when Trump called for the Federal Reserve to to “accept the GIFT” of negative interest rates on Tuesday, a layman might have reasonably interpreted his proposal as the cockamamie fantasy of a certified crank. But the idea that America’s central bank should set benchmark interest rates below zero — which is to say, that it should start taxing the reserves of commercial banks instead of paying interest on them — is not peculiar to Trump. In fact, many respected economists believe that the U.S. should embrace the policy, which is already in effect in Europe and Japan. Further, as of earlier this week, Wall Street investors were betting that the Fed will bring interest rates below zero by mid-2021 in order to promote recovery from the coronavirus crisis.
Nevertheless, Fed chairman Jerome Powell said Wednesday that while the central bank will continue taking a wide range of ambitious measures to ease credit creation and the restoration of growth, negative interest rates will not be one of them.
“I know there are fans of the policy, but for now it’s not something that we’re considering,” Powell said. “We think we have a good tool kit, and that’s the one that we will be using.”
Powell’s remarks are unlikely to put this debate to rest. As of this writing, America’s unemployment rate is likely over 20 percent. In April, U.S. consumer prices saw their steepest monthly decline on record. Barring some economic and public-health panacea, America is going to be battling high unemployment and the threat of deflation for many months if not years to come. With the congressional GOP’s appetite for fiscal stimulus already waning, the Fed will have to shoulder much of the burden of promoting full employment. And with benchmark interest rates already near zero-bound, there are only so many tools left in the central bank’s kit.
Here’s a quick rundown of the case for Trump’s desired monetary policy and why the Fed is so reluctant to adopt it.
On one level, the argument for negative interest rates is straightforward. When unemployment is high and inflation is low, the Federal Reserve traditionally cuts benchmark interest rates to boost demand and investment. By lowering the cost of borrowing, the central bank increases consumers’ (debt-financed) purchasing power, investors’ inclination to supply credit to risky enterprises, and firms’ willingness to make capital expenditures — all of which serve to increase the economy’s total demand for labor and, thus, bring down unemployment.
But thanks to a combination of slow growth, high inequality, and aging populations, real interest rates have been declining throughout the industrialized world for decades. In the years since the 2008 crisis, the Fed has found that raising benchmark rates far above zero is incompatible with hitting its 2 percent inflation target — even with super-low interest rates, demand hasn’t been robust enough to put much upward pressure on prices.
Thus the only way for the central bank to implement its signature crisis response — giant interest-rate cuts — is to go negative. In theory (and limited practice), the effect of a rate cut that dips below zero should be much the same as any other: It gives commercial banks less incentive to hold excess reserves with the Fed and more incentive to invest in riskier assets, thereby bringing down the cost of credit for households and firms.
Moreover, by pushing down interest rates in advanced economies, such a policy would provide much-needed relief to the world’s poorer nations. As the coronavirus crisis has obliterated global demand for commodities and made international investors more risk averse, many developing countries are struggling to find markets for their export industries and secure capital to finance their governments. Meanwhile, as those nations’ domestic currencies weaken, the weight of their (often dollar-denominated) debts grows heavier, limiting their capacity to pursue fiscal stimulus and social-welfare spending. Alleviating their plight will require more than monetary policy, but if America adopts deeply negative interest rates, it would simultaneously increase investors’ appetite for developing nations’ bonds and ease the developing world’s debt burden by weakening the dollar. Such a policy would not be purely altruistic; the U.S. economy does not stand to benefit from soaring poverty and political instability throughout emerging markets.
To be sure, negative interest rates do present hazards that merely low interest rates don’t. Chief among these is that the threat of cash hoarding: If individuals and institutions are effectively taxed for holding their savings in banks, they may be tempted to keep their dollars beneath their proverbial mattresses. But this has been less of a problem in Europe and Japan than many had anticipated. What’s more, as Harvard economist Kenneth Rogoff argues, there are fairly simple things the U.S. can do to discourage large-scale hoarding by pension funds and financial firms, such as phasing out large-denomination bills and implementing time-varying fees for large-scale redeposits of cash at the Federal Reserve.
Finally, unlike some of the crisis measures the Fed has already pursued, negative interest rates have already been test-driven — and, in the estimation of the European Central Bank, proved effective. In a report released in December, the ECB concluded that its experiment with negative rates had increased growth and inflation and made more-conventional stimulus policies more effective.
Negative interest rates may come with some risks. But then, so do the Fed’s current approaches to promoting credit creation. As Rogoff writes:
Right now, in the United States, the Federal Reserve — supported both implicitly and explicitly by the Treasury — is on track to backstop virtually every private, state, and city credit in the economy. Blanket debt guarantees are a great device if one believes that recent market stress was just a short-term liquidity crunch, soon to be alleviated by a strong sustained post-COVID-19 recovery. But what if the rapid recovery fails to materialize? What if, as one suspects, it takes years for the US and global economy to claw back to 2019 levels? If so, there is little hope that all businesses will remain viable, or that every state and local government will remain solvent.
A better bet is that nothing will be the same. Wealth will be destroyed on a catastrophic scale, and policymakers will need to find a way to ensure that, at least in some cases, creditors take part of the hit, a process that will play out over years of negotiation and litigation. For bankruptcy lawyers and lobbyists, it will be a bonanza, part of which will come from pressing taxpayers to honor bailout guarantees. Such a scenario would be an unholy mess.
Is this really a safer way of providing monetary stimulus than simply pushing down interest rates economywide, zero-bound be damned?
The case against negative rates is also simple: They offer great risk and little reward. Assuming you forbid banks from passing on negative rates to their small depositors (likely a political necessity), the policy would put pressure on lenders’ profit margins, potentially leaving them less resilient against further shocks. Negative rates could also chase investors out of money markets, which the U.S. economy relies on more than other national economies. Further, if pension funds and insurers are forced to hold money-losing government bonds, they might struggle to meet their obligations. And banks could take the incentive to chase risk too far, thereby inflating financial and housing bubbles. Sweden’s Riksbank abandoned negative rates last winter after concluding that keeping the policy in place for an extended period of time risked spurring harmful changes in the behavior of economic actors.
Given these downside risks, the stimulative “yield” on negative interest rates looks rather piddling: In its rosy estimate of the policy’s success, the ECB estimated that negative rates had increased annual inflation by a whopping 0.07 percentage points, making them less effective than bond-buying or forward guidance.
The Fed reportedly sees so-called yield-curve control (YCC) as a more promising emergency means of lowering borrowing costs. YCC is similar to quantitative easing (QE), in which the central bank lowers long-term interest rates by buying up government bonds. But under YCC, instead of buying a set quantity of bonds, the central bank sets a target price for long-term bonds, and then commits to buying up as many as necessary to maintain that price (since there is an inverse relationship between a bond’s price and its yield, inflating the price of bonds lowers their interest rates). In theory, once the market internalized the Fed’s commitment to defending its target price, the central bank would no longer have to buy up large amounts of bonds to defend that price; traders would simply stop selling bonds to private investors for anything less than they could get at the Fed. This would mean that the central bank could get the impact of QE without significantly expanding its balance sheet; the target price would just become the market price.
As long as Jerome Powell still has YCC left in his kit, it’s unlikely that he’ll turn to negative rates. But if his preferred implements prove inadequate to the task of reviving growth and inflation — and the Republican Party continues to starve the U.S. economy of the fiscal support it requires — the Fed chair may be forced to reach into the darker corners of his toolshed.