Evan Soltas
Apr 8, 2012

Below Zero

The Fed, the zero lower bound, and negative nominal interest rates?

Manuel Montori, like me a student at P.E.A very interested in economics, joins us as a guest blogger. (He was on the victorious YUEA team.) He's giving blogging a try, and if it works out, this blog may relocate in a month or so to another name, where he and I are both writers. We won't always agree, of course, but I see that many of the best econblogs are team efforts, with a handful of authors. More information if and when that time comes.

An interesting idea:

Some alternate Taylor rules (e.g., Mankiw & Krugman's) suggest that interest rates should still be substantially negative, but typically we say that the Federal Reserve faces a zero lower-bound on nominal interest rates. This comes out of a basic arbitrage argument. Since cash has a 0% nominal interest rate, lenders have no reason to ever dip below that rate.

Of course we can have negative real interest rates, but that implies inflation, and what central bank wants to promise high inflation and risk having an inflationary spiral on its hands? Certainly not the Fed. For a policy like this to work, management of inflation expectations would have to be spot-on. (One option here is price-level targeting, which also has quite a bit of potential).

Let's rewind. We've said that lenders have no reason to dip below zero and that is that, but there is one lender willing to go below zero: the Fed. Now it's likely the Fed would only pay a very slightly negative interest rate at first—maybe 25 basis points. The concept is simple: through some avenue, you borrow money from the Fed, and the Fed pays you to take this money and do with it what you will. More people take on the kinds of investment projects we need to boost our economy out of the post-recessionary blues, and everybody wins.

Is this a reasonable plan? There's some concerns, and managing them well would be important to avoid a fiasco: the arbitrage logic here is reversed: who wouldn't borrow when they're being paid to do so? You don't even have to do anything with the money, just hold it and make a tidy sum when it comes time to repay. If this happened on a large scale, the point of negative interest rates—to get people to invest that money—would fail.

An alternative is for the Fed to channel banks, and this seems more reasonable to me (though it's not perfect). In this case, the Fed would pay banks some sum of money for every dollar they lend, or maybe just for every dollar of excess reserves they pay. We can see a similar story arise here, where banks basically say, we'll lend you this money because it's going to make us more money than letting it sit, but don't go out and do anything crazy with it. That would be a risk-minimizing instead of a profit-maximizing situation, and people seeking to undergo large investment projects lose out again. But at least in this scenario, the Fed can exercise influence over banks and ensure their money is being used to lend to the kinds of lenders they want.

As a side note, this policy essentially enables the Federal Reserve to conduct fiscal policy, or at least a weird amalgam of fiscal and monetary policy. Our arbitrage logic suggests that if the Fed didn't regulate strictly who received the money involved in the negative nominal interest rate program, (almost) everyone would borrow money and pay back a slightly smaller sum. As long as the amount of money an individual could borrow was in some way capped, this essentially amounts to a subsidy. Individuals who choose to partake in the program are practically being handed the difference between what they borrowed and what they have to pay back.

Seems like a useful tool for a severe, liquidity trap recession with an uncooperative Congress. We're lucky nothing like that would ever happen in the real world.