Friday, January 9, 2009

Can the Fed Target Interest Rates Below the Zero?

Yes. I have posted here previously on how we have actually seen nominal interest rates below zero, including recently for both the actual federal funds rate and certain Treasury bill rates. During August to November of 2003, the repo market rates regularly went negative, this being the market the Fed normally uses for controlling the federal funds rate. And Japan had negative rates off and on in the late 1990s. Thus, if actual rates were to go negative and stay, the Fed could push the target rates below zero. This situation might well arise if the economic crisis worsens severely, and we fall into deflation. This would open up a new tool for the Fed, overcoming the limits of the liquidity trap.

The main theoretical argument for why interest rates cannot be negative, or not over a sustained period, as it is now clear that they can be so for at least short periods of time, has been the argument of cash as an alternative. That there was a lot of cash around in the 1930s may well have been why we never saw negative interest rates during that period of deflation and extreme economic decline. However, now cash is a tiny fraction of the money supply and of wealth more generally. It is not a meaningful alternative to government securities on a large scale for serious wealth holders, and such alternatives as checking accounts or CDs are all ultimately backed by government securities anyway, if the FDIC were to go under in a general further wave of bank collapses. Under such circumstances, the negative interest rate tool may be the only way out, especially if this follows a failed fiscal expansion.


BruceMcF said...

The relevant cash is of course not notes but checking account deposits ... for one thing, there is a size of cash transaction at a bank that triggers police interest in whether the person is engaged in money laundering for the illegal drug trade and other transactions.

And standard practice at banks for checking deposits with minimum balances over a certain amount is that the account is free.

So it'll be demand by institutions rather than wealthy individuals that are pushing nominal interest rates down below zero, because in the situation faced by institutions, the perceived sum total of return to liquidity, carrying cost, income and capital gain is higher than for competing short term financial assets, even with a small negative entry in the income column.

A negative nominal return is unusual, but in the current process of deleveraging, with large numbers of institutions on the same sides of large numbers of financial markets, its certainly not a staggering surprise.

However, expecting negative nominal interest rates to operate as a stimulus during the conditions that permit negative nominal interest rates to occur seems implausible. In order for indirect stimulus to occur as a result of lower interest rates, there has to be an increase in leverage, and that assumes away the conditions that allow a nominal negative interest rate to occur.

Myrtle Blackwood said...

Large institutions are settling for a negative interest rate at a time when a viable global ecosystem is unpriced and likely to remain so right up to the time that we all become extinct.

If I had a lot of money to make a loss on I would offer to make alterations to the houses of people to make them more energy efficient. In return the householders could pay 90% of the savings they experience in energy costs back to me until such time as the debt was paid off, perhaps also with some fair level of interest.

The removal of some of the world's economic 'externalities' would be a huge bonus.

Barkley Rosser said...


You may be right that the conditions that would allow for negative target rates would be so extreme that there may not be much leveraging effect from such a move. However, there would presumably be more than if the target rates were left at zero.


There is a large literature on the ethics of using zero or near zero discount rates in evaluating environmental policy such as with regard to climate change so as not to short change more distant future generations. I have seen theoretical literature on this issue that has allowed for negative discount rates that would value the future more than today.

Anonymous said...

Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.

In a Liquidity Trap although Saving (S) is abnormally high investment (I) is next to 0.

Hence, the Keynesian paradigm I = S is not verified.

The purpose of Quantitative Easing being to lower the yield on long-term savings and increase liquidity it doesn't create $1 of investment.

In a Liquidity Trap the last thing the Market needs is liquidity.

Quantitative Easing does diminish the yield on long-term US Treasury debt but lowers marginally, if at all, the asked yield on long-term savings.

Those purchases maintain the demand for long-term asset in an unstable equilibrium.

When this desequilibrium resolves the Market turns chaotic.

This and other issues are explored in my tract:

A Specific Application of Employment, Interest and Money
Plea for a New World Economic Order


This tract makes a critical analysis of credit based, free market economy, Capitalism, and proves that its dysfunctions are the result of the existence of credit.

It shows that income / wealth disparity, cause and consequence of credit and of the level of long-term interest-rates, is the first order hidden variable, possibly the only one, of economic development.

It solves most of the puzzles of macro economy: among which Unemployment, Business Cycles, Under Development, Trade Deficits, International Division of Labour, Stagflation, Greenspan Conundrum, Deflation and Keynes' Liquidity Trap...

It shows that no fiscal or monetary policy, including the barbaric Quantitative Easing will get us out of depression.

A Credit Free, Free Market Economy will correct all of those dysfunctions.

The alternative would be, on the long run, to wait for the physical destruction (through war or rust) of most of our productive assets. It will be at a cost none of us can afford to pay.

In This Age of Turbulence People Want an Exit Strategy Out of Credit,

An Adventure in a New World Economic Order.

A Specific Application of Employment, Interest and Money [For Economists].

Press release of my open letter to Chairman Ben S. Bernanke:

Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.

Yours Sincerely,

Shalom P. Hamou AKA 'MC Shalom'
Chief Economist - Master Conductor
1776 - Annuit Cœptis.

Barkley Rosser said...


I agree that in severe recessions/depressions, monetary policy becomes "pushing on a string." What may be involved here is avoiding having monetary policy become "pulling the economy back by a string" (or to use the other old chestnut, "keeping the horse from drinking the water"). The problem is that in a serious deflation, holding to a zero bound can lead to restrictively high real interest rates. Simon Johnson is pointing out that right now, forecasts of inflation according to certain financial market indicators are for negative 4%, which at a zero nominal rate means a positive real 4% interest rate, which would be restrictively high. In such a situation, negative target nominal rates may not fuel recovery, but they may help avoid an even worse downturn.

Myrtle Blackwood said...

Peter Schiff reckons the Fed will be a big purchaser of Treasuries soon. It has recently announced "a strategy designed to bring down long-term interest and home mortgage rates through unlimited Treasury bond purchases". Also the U.S. government is issuing "mountains of new debt to finance the multi-trillion annual deficits planned by the Obama Administration". When this happens speculative holders of existing debt [and those privileged corporations that have been gifted with US treasuries in exchange for their toxic financial securities] will be offering their bonds for sale as well. This will lead to a complete collapse in the bond prices unless the Fed intervenes to significantly increase its buying.

When this happens Schiff believes that those buying (and gifted with US Treasuries) now will be positioned to unload their holdings at good profit when the Fed buying spree begins and the price of treasuries rise as a result.

The Fed's Bubble Trouble
Peter Schiff. Jan 10, 2009

Barkley, thanks for the info about negative interest rates and valuing our future. Will look into the literature.

Barkley Rosser said...


You're welcome on the discount rate stuff. That has been central to the debates over the Stern Report and all that.

Regarding Schiff's argument, maybe or maybe not. What has happened to the Fed's balance sheet most recently has been that it has unloaded Treasuries, which is what it mostly held in the past, in order to put all this weird stuff on it, including junk from Europe through the European Central Bank, such as the detritus from the collapse of Structured Investment Vehicles (SIVs) in European banks (that to the tune of about $600 billion). If they unload some of that, they may pick Treasuries back up again, but I think in the near term everybody is hoping that the Chinese (and to a lesser degree the Japanese and some other East Asians) will pick them up. If they do not wish to, then Schiff's scenario could come to pass.

Myrtle Blackwood said...

Hmmmm...the scenario of waiting for the 'Chinese' and 'Japanese' to pick up US treasuries (debt) doesn't look that hopeful....Unless it's a US-owned corporation or corporate conglomerate dressed up (in the somewhat misleading Treasury stats) as 'foreign'*.

[* Last time I checked the US Treasury wasn't distinguishing, under the term 'foreign', between a foreign-owned corporation operating overseas and a US-owned corporation established in a foreign country.]

Barkley Rosser said...


It is what we have been doing for years, and many of us thought that the crisis would be about them not wanting to do it anymore. As it is, this crisis has been so bad we have had this bizarre "rush to safety" to the US dollar, with them apparently willing to keep doing it, at least for the meantime out of fear of what would happen if they did not. But, one of these days...

Myrtle Blackwood said...

Barkley, here's the latest I've got on China (US treasuries-related).

Capital flees from China. China's foreign exchange reserves had fallen for the first time since December 2003. (No specific data provided of when that happened or by how much.) China's central bank said Tuesday it will strengthen scrutiny of cross-border capital flows and study ways to tackle "abnormal changes" in the balance of payments. The People's Bank of China said it will check the validity of trade payments and step up supervision on individuals carrying foreign currencies in and out of the country. “I would assume "strengthen scrutiny of cross border capital flows" means "tighten foreign exchange controls even further." We may be also seeing a reversal of FDI investment as newly needy multinationals unload their stakes in Chinese companies to shore up their balance sheets, as Bank of America has. BofA is selling a $2.83 billion chunk of its holding in China Construction Bank (5.62 billion shares, or nearly 13 percent of its holding - The stake represents about 2.5 percent of Construction Bank, and will leave Bank of America with a 16.6 percent holding in the Beijing-controlled lender once the sale is completed. BoA will most definitely sell more. They need the money.") ndk said: “ Apparently right now China is defending against a fall in the yuan, instead of a rise in the yuan, as their reserves are falling. To do so, they might sell some of their treasuries, or more likely agencies, into the open market for dollars. Then, they would sell the dollars to repurchase some yuan. The yuan are then essentially retired, resulting in a contraction in the monetary base. A further rise in U.S. real interest rates could result.”

More Bad News Out of China, Including Capital Flight
Naked Capitalism. Wednesday, January 7, 2009

Meant to post this earlier but having trouble grabbing computer time between hard labour on the block.