Scott Sumner  

Interest rate pessimism

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Back in the 1970s, there was much pessimism about whether the Fed could get inflation under control by raising interest rates. Rates kept going higher and higher, and yet inflation also kept increasing. Markets did react to unexpected rate increases as if they were disinflationary, but the longer run pattern (high rates and higher inflation) led people to be very pessimistic about the ability of rate increases to tame inflation.

Today there is much pessimism about whether lower interest rates can boost inflation. Markets do react to unexpected rate cuts as if they are expansionary, but the longer run pattern (low rates and low inflation) leads people to be very pessimistic about the ability of rate cuts to boost inflation.

If I went back in time to 1979 and tried to make the case for rate increases, people would have said; "But the Fed has already raised rates to 12% and inflation keeps soaring. What makes you think more of the same failed policy would succeed?" If I said, "then raise them to 20%" people would have just rolled their eyes, like I wasn't being serious. Well, soon after Paul Volcker did raise them to 20%, and inflation fell from double digits to about 4% after 1982.

There's a lesson here for today. It's now fashionable to complain that negative rates aren't doing any good; after all, the markets continue to show increased pessimism about growth and inflation, "despite" the negative rates. But just as the 12% interest rates were not "tight money" in 1979, the negative rates in Europe and Japan are not easy money. On the other hand, still lower rates of IOR would probably make policy more expansionary.

Having said that, I do agree with Tyler Cowen's recent claim that there are more effective ways of doing monetary stimulus than negative IOR. But I'm not as pessimistic as he is about the effects of negative IOR:


More evidence that negative interest rates aren't working
. They are not just a reflection of bad conditions, the tax on intermediation seems positively harmful, and there are ways to run an expansionary monetary policy which don't involve this tax.

I don't see much evidence that negative IOR is not "working" in the article he links to, although I do agree that low rates in general are probably a negative for banks, and indeed for the entire economy.

Given that I've used the "tax on reserves" metaphor for negative IOR, you may be surprised to learn that I don't quite accept the claim that negative IOR is a tax on intermediation. A tax creates a wedge between the equilibrium free market price, and the actual price inclusive of the tax. But we don't see that with negative IOR. Indeed the rate of interest charged to banks on excess reserves is generally lower (I mean less negative) than the rate on risk-free government bonds. So in a sense there is still a subsidy involved.

Recall that in the old days when IOR was zero and T-bill yields were positive, the spread was considered an implicit tax on required reserves. I think that's right. But by that logic we now have a subsidy. I suppose you could argue that the entire structure of negative rates on government securities is artificial, and hence in some sense a "tax." But if you really want to go down that road, you are forced to view positive interest rates on government bonds as a subsidy. After all, a subsidy is just a negative tax.

When I argued that negative IOR was a tax on bank reserves, I meant that it drove a wedge between the rate of interest on cash (zero) and reserves, which are the two forms that base money can take. But if we think about bank balance sheets, they hold reserves and bonds. And if the yields on bonds are lower than on reserves, then I fail to see how negative IOR is the problem. After all, banks could choose to hold only a tiny amount of excess reserves, as they did in America before 2008. Negative IOR often doesn't even apply to required reserves. The fact that Japanese and European banks choose to hold massive quantities of reserves is presumably due to the fact that they pay an above market rate, a rate higher than government bonds. So in that sense there is no tax "wedge" on intermediation. Banks are not being punished for holding reserves; they are being rewarded, relative to market rates.

The real problem at banks is the negative rates on bonds, and those are equilibrium market rates, indeed they are still higher than the Wicksellian equilibrium rate. In theory, banks ought to be able to offset this with even more sharply negative rates on deposits. But for some reason they are not able to do this very well, at least so far. Perhaps this is due to the fear that depositors will switch to cash in safety deposit boxes, or perhaps just due to the public relations hit they would take. In either case, banks tend to avoid negative interest on deposits. So if there is any sort of (informal) zero lower bound on deposit rates, then banks really are hurt by negative interest rates. But not necessarily negative IOR.

So I sympathize with Tyler's concern about negative interest rates in the broader sense. Driving them even further negative won't solve the problem facing banks, unless the policy is able to ultimately lead to much higher nominal rates. So far central banks have been too reactive, they need to get out ahead of the curve. They won't have "done enough" until further monetary stimulus leads to higher bond yields, not lower.

Volcker's high interest rate policy eventually led to much lower rates, once inflation came down. The developed world's central banks need to be aggressive enough to actually raise inflation (and even better NGDP growth) significantly. That's the only durable solution to the low interest rate problem currently facing banks. Anything else will just be a band-aid.

I know my claim seems implausible, given everything going on right now. But just think how implausible I would have seemed in 1979, claiming 12% rates were actually easy money, and that central banks needed to do still more rate increases, much more.

And finally, it's worth noting that Volcker's success was not just caused by sharply higher interest rates, he also changed the Fed's approach to monetary policy, shifting (at least the rhetoric) from interest rates to the money supply, as the indicator of monetary policy. That is, he adopted the monetarist framework (until inflation was under control.) Of course the market monetarist framework would replace the money supply with NGDP growth expectations. That sort of shift would likely be far more effective than driving the IOR ever deeper into negative territory.


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COMMENTS (15 to date)
Alexander Hudson writes:

Good post, Scott. At the end of the day, the Fed needs to stop tinkering with interest rates (negative or otherwise) and adopt a totally different policy regime.

By the way, I was pleasantly surprised to see many of your arguments being made over at Vox. (And from someone other than Yglesias, who, unfortunately, doesn't post about monetary policy as often since moving there.) I was getting worried that literally no one on the left cared about these issues.

HL writes:

Another superb post! Great comparison to the Volcker episode.

Indeterminacy and the initial motivation behind interest rate rules...one of those essential things people learn in grad school macro courses and somehow fail to apply symmetrically in their professional lives. Frustrating to watch and argue against.

But the high denomination note debates in the ECB and some economic circles (Summers last night on removing any note carrying more than USD 50-100 OF value) gives me some hopes that the world is moving in the right direction, though slowly.

Philip George writes:

"After all, banks could choose to hold only a tiny amount of excess reserves, as they did in America before 2008."

Are you sure about this?

This is what Ben Bernanke and Donald Cohn said yesterday: "Reserves are deposits banks have at the Federal Reserve; some are required by law to be held against checking deposits, but banks also hold reserves at the Fed in excess of requirements. Importantly, the amount of Fed deposits held by the banking system as a whole is determined by Federal Reserve open market operations, not by the banks themselves."

See http://www.brookings.edu/blogs/ben-bernanke/posts/2016/02/16-fed-interest-payments-banks?rssid=Ben+Bernanke

Benjamin Cole writes:

Nice post.

"The developed world's central banks need to be aggressive enough to actually raise inflation (and even better NGDP growth) significantly. That's the only durable solution to the low interest rate problem currently facing banks. Anything else will just be a band-aid."--Sumner.

Exactly! This dainty central bankerly tweetybirding around with nudging rates this way or that, and constantly sermonizing in public about inflation is a recipe for failure. If you run a failing nightclub, hiring schoolmarms as operators won't help.

The ECB, Fed, Bank of Japan, People's Bank of China, and perhaps the BoE need to commit to aggressive QE for several years, the taper of which will depend not on the calendar, but the results. Open-ended in other words.

I would prefer marrying QE to FICA tax cuts (or labor taxes in other nations), and I happy to say Michael Woodford is evidently a supporter of this idea.

http://www.voxeu.org/article/helicopter-money-policy-option

When you see fancy restaurants hiring fat waitresses and we are wiping our rear apertures with Benjamin Franklins, then you will know you can consider ramping down QE in a couple more years.

BC writes:

Re: banks' reluctance to pay negative interest on deposits. Sticky wages lead to unemployment. Sticky interest on deposits ought to lead to banks' unwillingness to accept deposits from some would-be depositors and/or unwillingness of some savers to buy negative-yielding bonds instead of depositing money into zero-interest bank accounts. Any evidence that this, especially the former, is happening?

Jose Romeu Robazzi writes:

Great Post, people often forget that past decisions that are now history were tough ones to make. We take for granted that they worked and therefore they should be "obvious". It takes paradigm shifts to solve thought problems. And institutions are bad at that sort of thing ...

Steve Fritzinger writes:

Two questions.

In a global world, where some central banks are paying IOR and some are trying QE (are any doing both), what is the overall effect on the global economy? Couldn't banks, investors and companies move to the country/currency that is most attractive, making the whole thing a wash? Or at least totally unpredictable?

Second, you says:

If I went back in time to 1979 and tried to make the case for rate increases, people would have said; "But the Fed has already raised rates to 12% and inflation keeps soaring. What makes you think more of the same failed policy would succeed?" If I said, "then raise them to 20%" people would have just rolled their eyes, like I wasn't being serious. Well, soon after Paul Volcker did raise them to 20%, and inflation fell from double digits to about 4% after 1982.

I totally agree, yet this is the same argument "vulgar keynesian" make when stimulus programs fail. In that context, I find the argument totally unconvincing.

Is there a way to know a priori when "more of the same" will likely work and when it's throwing good money after bad? Or is it just down to ideology?

Scott Sumner writes:

Alexander, Yes, Timothy Lee does a very good job.

Thanks HL, I'm very worried about the war on currency holders.

Philip, That's mistaken. The Fed determines the monetary base; the commercial banks determine the share of base money held as reserves.

BC, Good question, and I don't know the answer. One question worth looking at is service charges on deposits--have they increased?

Jose, You said:

"And institutions are bad at that sort of thing ..."

Exactly.

Steve, You asked:

"Couldn't banks, investors and companies move to the country/currency that is most attractive, making the whole thing a wash? Or at least totally unpredictable?"

IOR applies to dollar reserves, even if held in European banks. I assume the reverse is also true, but am not certain.

Gemmoo writes:

Great post.

Scott, BC:

In Japan, money market funds are no longer accepting new deposits and fund managers are looking to force depositors out of their funds. This is especially true of money reserve funds, where fund managers have to make up for losses if the value of the fund "breaks the buck."

Moreover, banks are considering increasing commissions and fees charged to corporations on demand deposits. They have not yet moved to increase fees on demand deposits held by retail depositors but the interest rate has been cut from an average of 0.025% to 0.001% in the Tokyo area.

Japanese consumers are used to keeping their money out of the bank. It was only recently that money began flowing from under the mattress and back into the banking system. That should start to reverse.

In the meantime, savers are looking at alternatives to bank deposits. One scheme that is attracting a lot of money is "Friend of the Store" clubs at major department store chains. Shoppers can deposit amounts typically between Y30,000 and Y50,000 monthly into their Friend of the Store account and get 5% to 10% discounts on their purchases plus a store credit equal to one month's deposit every 12 months. It works out to a return of about 8% annually. The only problem is, you have to spend all of your money as store credits. You can't withdraw the cash or any bonuses you might receive. But, if you are a shopaholic, it could be a good deal. Better than putting your money in the bank, right?

ThaomasH writes:

Scott,

Maybe your recollection is better than mine, but I think the inflation "pessimism" was about the ability or IR to bring inflation down w/o causing "too much" unemployment.

There may be a similar reading of today's (anti) inflation pessimism, that low ST interest rates cannot raise inflation without going "too negative" or requiring lowering longer term rates or renewed QE or risking breaching the inflation ceiling. In other words it's no really about the magnitude of the parameter, but about constraints on what the value of the IR would have to be without violating some other constraint. If you have completely internalized (positively or normatively) those other constraints, then you will say that IR are "impotent."

bill writes:

In our current environment, simply lowering IOR to 0% would probably be stimulus enough that the Fed would have to start shrinking its balance sheet (and both of those would be good things). But that's just conjecture.
Separately, I'm really angry that the Fed is paying bank 50 bps for overnight money (IOR) when that exceeds the market rate. It's outrageous.
Excellent post.
Also, since the Fed says its target is 2% inflation and then ignores the market forecast for inflation (below 1%!), I'm afraid that if you succeeded in setting up an NGDP market, that the Fed would ignore that too. People want to feel important, so they sit around at board meetings talking all sorts of insights and angles. Following a simple NGDP futures market forecast will not happen unless Congress required it by law.

Hans writes:

For all you dear and beloved Fed-O-philes,
there will be no rate increases for the
current calendar year.

In fact, there will be no normalization of
interest rates for the foreseeable future. FedZero, will continue unabated, until federal governmental unit spending comes under control.

All Central Bankers are now acting in concert to
liquefy their monetary policies and devalue their home currencies at the same time.

The race to the bottom is in full swing and the consequences will not be very pleasant.

Scott Sumner writes:

Gemmoo, Thanks for that story, but that raises the question of where the stores put that money--it remains a hot potato.

Thaomos, You could say the same about today. No one denies that a sufficiently expansionary monetary policy will get the job done, but they do question whether a politically acceptable form of monetary stimulus would be sufficient. So I still think it's a good analogy.

Bill, That's why I favor level targeting, the central bank cannot ignore a level target mandate.

bill writes:

Great point about level targeting.

bill writes:

PS - That's probably why the Fed is so resistant to level targeting.
[smiley face]

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