Economists used to think below-zero interest rates were impossible. Necessity (as central banks see it) is the mother of invention, though; and multiple central banks now think negative rates are a necessary step to restore growth.
Are they right? Will negative rates pull the global economy out of its funk? Probably not; but for better or worse, several central banks are already below zero. The Federal Reserve just sent its clearest signal yet that it is headed that way, too. The Fed has warned banks to get ready. We had all better do the same.
This week’s letter has two parts. The first deals with some of the practical aspects of negative rates and what the Fed is really signaling. The second part, which is somewhat philosophical, deals with why the Fed will institute negative rates during the next recession. This letter is longer than usual, but I think it’s important to understand why we will see negative rates in the world’s reserve currency (and the currency in which most global trade is conducted). This policy trend is truly a foray into unexplored territory.
Be Careful What You Wish For
The idea of negative rates isn’t new; what’s new is the willingness to try them out. The Ben Bernanke quote above comes from a November 2, 2009, Foreign Policy article in which the Fed chairman wrestled with how to keep inflation at the “right” level in a weak economy.
Set aside the question of whether there is any “right” level of inflation. As of six years ago, the head of the world’s most important central bank thought no one would ever lend at a negative interest rate. We now know he was wrong, at least with regard to Japan and most of Europe. Central banks there have instituted negative rate policies, and people are still borrowing and lending.
The Fed staff has also speculated on the possibility. Earlier this month my good friend David Kotok sent around links to several academic and central bank negative-rate studies. One was a 2012 article by Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York. Their title tells you what they thought at the time: “If Interest Rates Go Negative… Or, Be Careful What You Wish For.”
Their point was less about the theoretical wisdom of NIRP and more about the actual potential consequences. They believed we would see a variety of odd responses to a very odd policy situation. All kinds of incentives would reverse, for starters.
Under negative deposit rates, buyers would want to pay their invoices as soon as possible, while sellers would want to delay receiving cash as long as possible. Think about your credit card bill. If you normally spend $10,000 a month, your best move would be to send the bank that much money before you spend it, then draw down the resulting credit balance. The bank would no doubt try to discourage this practice. Could they? We don’t know.
Garbade and McAndrews throw out another interesting idea: special-purpose banks: