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Below Zero, Above Average

In the oft-misunderstood world of monetary policy, a major debate rages about the role of negative interest rate policy in central banking. Central banks, like the US Federal Reserve (the Fed) and the European Central Bank (ECB), are the primary government institutions that set monetary policy. Their most important tool to influence the economy is their ability to determine interest rates. In the US, the Fed sets the federal funds rate, which is a target interest rate for overnight interbank loans, or brief loans banks use to ensure they meet federal requirements for the amount of cash they must have on hand.

When the Fed changes these interest rates, it causes a ripple effect. It doesn’t just impact the amount banks must pay each other for loans; it also causes interest rates to shift across the economy, from credit card loans to mortgages. These movements are usually small — only a few percentage points — but more major changes can have distinct economic impacts. Between January and December 2008, for example, the Fed cut the federal funds rate from 5.25 percent to a range of 0-0.25 percent, an unusually dramatic move. This historic effort was an attempt to shorten the Great Recession. The basic idea is this: If interest rates on loans across the board are low, the total cost of borrowing becomes much lower, causing businesses and consumers to be more willing to borrow from banks and then invest that money. With cheaper loans, more consumers buy cars, appliances, and electronics, while businesses buy equipment, build factories, and invest in research and development. From there, the logic is simple: When more people buy more things, the economy improves. Indeed, these low interest rates, paired with the 2009 American Recovery and Reinvestment Act and other aggressive monetary policy, helped mitigate the US recession. Analysts suggest that this combination of policy tools was crucial in ensuring the 2007-2008 Great Recession lasted only 19 months.

Since dropping the interest rate in 2008, the Fed stayed its course until last December when a modest hike brought rates up to a range of 0.25-0.5 percent. Usually, such policy is a sign of a strong economy, but this time it’s not necessarily clear that’s the case. Although the unemployment rate has gotten back on track, many are still concerned with sluggish inflation rates, with most central bankers believing that about 2 percent inflation is healthy for an economy; inflation rates in the United States are still below this recommended threshold.

The current range of interest rates raises another concern: Should an economic crisis occur, the Fed would have few options to alleviate the problem. That is, if the Fed were faced with any substantial economic downturn, it would only be able to moderately lower interest rates before hitting what is called the zero lower bound (ZLB). The ZLB is exactly what it sounds like: the limitation in traditional monetary policy that interest rates cannot drop below zero. But for anyone familiar with basic arithmetic, the solution seems simple — allow interest rates to go negative. As simple as it sounds, the idea is unorthodox in monetary economics and brings its own set of challenges. That being said, the Fed should consider pursuing policies that would make it easier to drop interest rates below zero.

If the United States were hit by another recession this year, it would be difficult to imagine what the economic policy response would look like. Like all economic policy, the response can be broadly broken down into fiscal policy — that is, changes in spending and taxing — and monetary policy, changes in the money supply. On the fiscal side, any response would require congressional approval, and with current congressional gridlock, it seems hard to imagine a suitable compromise could be made. Even if some sort of fiscal policy were passed, historically that’s rarely been enough sans a powerful accompanying monetary response. In this case, the Fed would almost certainly drop interest rates back down to their near-zero rate, only to be left with little else to do except venture into the territory of negative interest rates.

Europe and Japan are currently implementing negative interest rates, and looking to these playbooks, the Fed would likely set its own negative interest rates between -0.2 and -0.4 percent. Negative interest rates require banks to pay the central bank to hold their reserves in its vaults. In theory, this passes off lower (or possibly negative) interest rates on loans to civilian or business borrowers, an effect that should then encourage borrowing and kick start the economy. However, to date, these anticipated effects have largely failed to materialize. In Japan, a month after the Bank of Japan began their negative interest rate policy in February of this year, borrowing and lending growth actually slowed while savings rose. In Europe, similar efforts in 2016 also resulted in lowered projections for growth and inflation — the opposite of what central banks were trying to achieve when they set negative interest rates.

There are two possible reasons why these efforts have not produced desirable results. The first is the issue of credibility. Just as decisions by economic actors depend not only on current conditions but also on people’s expectations of the future, so too does the impact of monetary policy. Specifically, the impact of monetary policy is contingent on whether the market thinks the central bank is committed to its stated goals. For the European and Japanese central banks, recent history has created a credibility problem, hampering the effectiveness of any policy, including negative interest rates. On the other hand, the Fed is a very credible institution. Through its pursuit of aggressive monetary policy in response to the Great Recession, markets believe in its consistency.

The bigger obstacle for the success of negative interest rates is one of tradeoffs: When faced with the option of putting money in a bank and paying a negative interest rate, versus simply holding onto cash, many will opt to keep their cash. Indeed, in the month after Japan announced negative interest rates, sales of safes spiked and large bills entered circulation at a larger rate, implying that the policy may have caused households to stuff cash under their mattresses. The problem is that without deposits, banks can’t make loans. If the cash-hoarding problem were to be severe enough, lending may drastically decline rather than increase — despite the incentives negative interest rates create for borrowers to seek loans.

This tradeoff is the largest obstacle for negative interest rate policy, and it’s rooted in the zero interest rate of paper money. Simply put, the bills in your pocket are neither becoming worth more nor less. While this may seem like an obvious and desirable trait of paper money, it’s a large hindrance in the pursuit of negative interest rates and changing it could prove crucial to the response of central banks to future economic crises. Miles Kimball, a professor of economics at the University of Michigan, has spent a lot of time thinking about this very problem and has constructed a simple way of solving it: divorcing paper and electronic money. Electronic money is the numbers on a bank’s computers; it includes checking accounts, savings accounts, and credit cards. Traditional interest rates affect this kind of money, but putting an interest rate on cash is much more difficult. So to solve the problem of people hoarding cash, paper money and electronic money would need to not have a one-to-one exchange rate. Just as one dollar does not buy one euro, one paper dollar would not buy one electronic dollar.

Admittedly, this policy is farfetched, and there is very little chance that it would be implemented tomorrow. However, if designed and executed well, a negative interest rate could be effective at incentivizing consumers to invest in things with real returns, whether that’s a new car, a new house, or the stock market. Nevertheless, establishing negative interest rates would likely come across as government overreach, a concern also voiced when the United States switched to fiat currency from the gold standard. But just as in 1896, when William Jennings Bryan argued that the struggling masses would be crucified upon the “cross of gold,” if the move to bimetallism was not made and if central banks are to be able to effectively react to economic crises, we must ensure that we are not crucified upon a cross of paper.

About the Author

Matthew Dudak '18 is the Data Editor for Brown Political Review.