Fed Vice Chair Explains Why The Fed Is Still Obsessing With Negative Interest Rates

Two months ago, and roughly 6 weeks before the Fed's first rate hike in 9 years, Janet Yellen warned that if the "outlook worsened, the fed might weight negative rates" adding that "negative rates could help encourage banks to lend."

Moments ago, in a speech titled "Monetary Policy, Financial Stability, and the Zero Lower Bound" delivered before the American Economic Association in San Francisco, the Fed's second in command, Vice Chairman Stanley Fischer while discussing the equilibrium real interest rate, or r* (or the real interest rate at which the economy would settle at full employment and with inflation at 2 percent, provided the economy is not at the ZLB), unexpectedly hinted once again at the potential advent of negative rates in the US, two weeks after the Fed's raised the interest rate to a 25-50 bps corridor except of course for December 31 when as we noted, the Fed Funds dropped to 0.12%, suggesting that banks are perfectly ok with hiking rates... except when it comes to quarter and year-end window dressing for regulatory, compliance and public filing purposes.

Specifically, Fischer discussed what steps, if any, can be taken to mitigate the constraints associated with the ZLB? His second answer: NIRP. To wit:

Another possible step would be to reduce short-term interest rates below zero if needed to provide additional accommodation. Our colleagues in Europe are busy rewriting economics textbooks on this topic as we speak-and also helping us to remember earlier discussions of negative interest rates by Keynes, Irving Fisher, Hicks, and Gesell.


* * *


... while it is hard to distinguish the effects of the rate cuts from those of concurrent asset purchase expansions, the easing appears to have been transmitted to assets of longer maturity and greater risk. Bond yields and bank lending rates declined, and, in the euro area, the volume of lending to corporations and households picked up notably. In addition, the rate cuts into negative territory have acted as expected through the exchange rate channel.


Negative policy rates have generally not been associated with the problems that likely were anticipated. Adverse effects on money market functioning have been limited. Cash holdings have not risen significantly in these countries, in part because of non-negligible costs of insuring, storing, and transporting physical cash. These favorable outcomes may be partly because significant shares of deposits at central banks in these countries are not subject to negative rates. It is unclear how low policy rates can go before cash holdings rise or other problems intensify, but the European experience has certainly shown that zero is not the effective lower bound in those countries.


Could negative interest rates be a policy response that the Federal Reserve could choose to employ in a future crisis? One possible concern with a strategy of this sort in the United States is the potential for destabilizing effects in money markets. For example, various observers have noted that negative rates could lead to scenarios in which money funds “break the buck” or simply shut down, either of which could generate strains in money markets. Another concern is whether the complex and interconnected infrastructure supporting securities transactions in the U.S. financial system could readily adapt to a world of negative interest rates. For example, similar to the types of issues addressed ahead of the year 2000, there could well be automated systems that simply are not coded properly at present to process transactions based on instruments with negative rates. All of these are, of course, transitional problems, but they might be sufficient to make a move to negative rates difficult to implement on short notice.

What about longer notice?

In summary: while the vice-chair admits there are problems with negative rates, Europe's "successful" experiment with NIRP so far suggests this could be transplanted to the US, and adds that any problems are ultimately "transitional", or nothing that can't be fixed if the Fed set its mind to it.

But enough about NIRP: what about rising rates even higher? Here is under what conditions the Fed would consider even more rate hikes in the future:

I believe that the real issue of whether adjustments in interest rates should be used to deal with problems of potential financial instability is macroeconomic, and that if asset prices across the economy--that is, taking all financial markets into account--are thought to be excessively high, raising the interest rate may be the appropriate step.

His conclusion: "Further discussion of this issue will probably bear considerable similarity to the analysis of how to deal with asset bubbles that took place in the United States in the decade starting about two decades ago." An asset bubble, which as everyone knows, the Fed failed to see until it is too late.

So, if in the Fed's opinion, asset prices are excessively high, "raising the interest rate may be the appropriate step" - this coming from the same Fed which failed to see "excessively high" asset prices during the past two bubbles. More importantly, this also means that if asset prices are "excessively low", well then the Fed will clearly lower interest rates, first to zero, and then to negative, because after the infamous Kocherlakota dot, with every passing month the Fed's obsession with NIRP as the logical "exit" from its rate hike "policy mistake" is getting more and more obvious.

* * *

Finally, to help the Fed with its quandary why the equilibrium real rate will never be able to rise, here is an explanation we posted a month ago using some very simple logic from Deutsche Bank:

One might argue for low “implied” equilibrium short rates via debt ratios. For example, if nominal growth is 3 percent and the debt GDP ratio is 300 percent, the implied equilibrium nominal rates is around 1 percent. This is because at 1% rates, 100% of GDP growth is necessary to service interest costs.


In this case, real growth would slow in response to rate hikes because productivity would stay weak at full employment and companies would be profit/price constrained around paying higher wages. Moreover, nominal growth would then slow even more than real growth does because inflation would fall to 1 percent or below.

DB's conclusion:

"This is the important policy error scenario because even a very shallow path of rate hikes might drive the real Funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle. As an aside, such a policy error could reinforce itself by causing structural damage that puts additional downward pressure on the equilibrium real rate. In this case the yield curve would flatten meaningfully, at least until the Fed actually reversed course by cutting rates."

Hence: the Fed's seemingly inexplicable obessions with negative rates.