The Fed Needs to be Ready to Go to Negative Rates and the Bank of Japan Needs to be Ready to Go Deeper Negative
No one knows what will happen once the pandemic is over. But there is a substantial chance that powerful aggregate demand stimulus will be necessary in many countries. The articles shown above talk about the US and Japan. Japan has already gone to negative rates. There is no reason it can’t go deeper into negative rates. If they are worried about the paper currency problem, they know what to do: I have given two presentations at the Bank of Japan about negative rate policy, including how to fully neutralize the paper currency problem.
Because a smaller fraction of transactions use paper currency in the United States, any worry about the paper currency problem should be more at the level of this worry in the European countries that have used negative rates. The European Central Bank is at -.5%, while the Swiss National Bank has been at -.75%. The Fed should not be worried at all about going that low.
In his op-ed shown at the top of this post, Narayana Kocherlakota suggests that the Fed is worried about the financial health of banks and that it shouldn’t be so concerned about the banks. Narayana’s argument can be strengthened greatly by pointing out that the Fed can take away almost all of the financial pain of negative rates from banks without any help from the US Treasury simply by having the interest on reserves stay zero, but capping reserves so that funds beyond that in an overnight repo-based facility go at negative rates. The higher the cap, the less financial pain banks suffer from negative rates. Of course, the cap has to be below the total amount that banks want to lend to the Fed in order for negative rates to prevail in the market. If that led to more financial pain than the Fed thought banks should face, the Fed could even raise the interest on reserves subject to the cap a bit. So the Fed doesn’t have to choose between banks and the health of the economy. At some cost to its own net worth, it can both hold banks’ bottom lines harmless and stimulate the economy with negative rates. And in practice, if the Fed goes to negative rates, I would bet that like other central banks using negative rates it would in fact take some measure to protect the bottom line of banks. So the idea that negative rates are harmful to banks is a red herring. It would only happen if either (a) a central bank knows the banks can handle it or (b) a central bank is stupider than the central banks in the real world that have used negative rates.
The ease with which central banks can neutralize any bad effects on bank balance sheets from negative rates seems not to be widely understood. I discuss this extensively in “Responding to Negative Coverage of Negative Rates in the Financial Times.”
Note that I am focusing on the potential need for negative rates once the pandemic is over. For example, in “The Wisdom of Jerome Powell” I write:
History may judge Jerome Powell in important measure on whether he is willing to use negative interest rates to get us out of the hole our economy is in some months from now. The “how” of negative interest rates is now well-worked out, the President of the United States is supportive of negative rates, and there is a clear legal path to negative rates in the United States. So there is no excuse not to use them if they are needed, as they are likely to be.
But in my debate with Narayana Kocherlakota, he gives cogent reasons for going to negative rates even during the current phase of the pandemic where it has huge economic effects. See “Narayana Kocherlakota Advocates Negative Interest Rates Now.”
For more on negative rate policy, see my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”