The danger of negative interest rates
In recent months a number of the world's central banks have veered into territory once unimaginable to most economists: negative interest rates.
Standard textbook theories hold that negative interest rates are infeasible because depositors always have the outside option of holding onto cash, which is storable and therefore pays an effective interest rate of zero. Recent experience and some expanding research suggest that zero is in fact not a binding floor on interest rates.
In our increasingly complex financial and monetary systems, currency is relatively unimportant and transactions costs mean that depositors may be willing to accept small negative rates of interest. In recent days, Fed Chair Janet Yellen has at least opened the possibility of the Fed following in the steps of some of the world's other central banks in moving policy rates into negative territory.
The tepid recovery from the Great Recession exacerbated by recent concerns about the health of the global economy and volatility in financial and commodities markets, has spurred calls for negative interest rates as a policy tool. Negative interest rates can be implemented by charging banks to hold reserves (which are deposits which commercial banks hold at central banks). This would encourage banks to move from sitting on cash to loaning it out, which ought to lead to more consumer and business spending. In this regard, the mechanism by which negative interest rates might impact the economy is no different than how a cut in interest rates from two to one percent ought to stimulate the economy.
Still, there are reasons to be skeptical that moving policy rates into negative territory would be the panacea that its supporters hope for. Although financial markets have been extremely volatile of late, credit conditions in the U.S. remain good – creditworthy households and businesses face no difficulties in acquiring credit at historically low interest rates. There is little to suggest that the U.S. financial system suffers from a lack of liquidity. There is every reason to expect interest rates to remain at historically low levels for several years, which is reflected in current long-term yields. For these reasons, while a movement to negative rates would likely have some positive effect on macroeconomic spending, there is no reason to expect the effect to be unusually large.
A movement into the territory of negative interest rates also comes with downside risk. Credibility is crucial for effective central banking. The Fed ought to be weary of appearing to react in a knee-jerk way to volatility in financial markets. While one can debate the merits of the recent decision to raise rates in December, reversing course in such quick fashion would risk eroding some of the Fed's hard-earned credibility. It could de-stabilize private sector expectations and lead to heightened uncertainty, both of which would be drags on near-term economic activity.
There are also downside risks to negative rates at an operational level about which we know little. While charging commercial banks to hold reserves sounds simple in theory, in practice, implementing negative rates requires sophisticated management of an increasingly complex financial system. The U.S. money market is the largest in the world, with trillions of dollars at play. The money market plays a crucial role in providing liquidity to help business meet short-term financing needs. Negative policy rates might risk a "break the buck" scenario, which could be extremely disruptive.
Given the tepid recovery and increasingly volatile global financial system, it is easy to sympathize with calls for ever more accommodative monetary policy. Negative interest rates may have some stimulating effect, but also come with potentially significant downside risks. Negative interest rates, and monetary policy more generally, are not a panacea. Most of the headwinds facing the global economy are outside the purview of monetary policy. Fiscal imbalances, demographic trends, slowing productivity growth, and the inevitable disruptions from structural change and globalization are all more pressing needs on which policy should focus.