The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.
The Fed has not adopted a negative nominal interest rate policy, but it could in the future. Federal Reserve Bank President, John Williams, and Federal Reserve Board nominee, Marvin Goodfriend, (here) and (here), respectively, suggest the Fed may have to pursue a negative interest rate policy to enhance the effectiveness of its interest rate policy in a low-interest rate environment. This essay discusses what negative nominal interest rates are and how the Fed would implement such a policy. In short, I explain the folly of negative nominal interest rates.
A negative nominal interest rate literally means that the lender pays the borrower interest to borrow from the lender: You lend me $100 for a year and a year later I give you $95. Ok, I’m ready to borrow. But I don’t want to lend on the same terms. “Can this really happen?” The answer is yes. But it takes some explaining. Conceptually, there is a “zero lower bound” on nominal interest rates. The idea being it is folly to lend $100 for a year and get $95 back. You’d be better off holding cash. Cash has a zero nominal rate of return—a year from now you would still have $100, not $95. Hence, nominal interest rates should never go below zero—the zero lower bound.
But they can and they have.
Short-term nominal interest rates were negative briefly in Japan in 1999. Having noticed this, one of my St. Louis Fed colleagues asked me how this could happen. I explained why it can happen and published the explanation (here). The reason is simple. The zero lower bound constraint, like many things economists talk about, only holds in an idealized world. In the case of the zero lower bound, it’s a world where it is costless to hold cash. In the real world, holding cash isn’t costless. Cash can be lost, stolen, or destroyed.
Moreover, the more cash you need to hold, the more likely it is that someone will want to relieve you of the burden. The costs are particularly high if you need to store large amounts of cash safely; the transportation and storage costs will be significant. If you need to store a large amount of cash, you might be willing to pay someone to borrow it from you. Conclusion: The lower bound on nominal interest rates is not zero in the real world. How negative interest rates will go depends on how costly it is to hold cash. The higher these costs, the more negative nominal interest rates can be.
“Would the Fed implement the negative interest rate policy by paying banks to borrow from the Fed?” Of course not! That would reduce the Fed’s income. The purpose of a negative interest rate policy is to reduce someone else’s income, not the Fed’s. No, the Fed would charge banks interest on their deposits with the Fed. The Fed imposes reserve requirements on banks that are based on a percent of bank’s checkable deposit liabilities, currently 10%. Banks can hold these reserves either in the form of vault cash (cash stored in bank’s vaults) or deposits with the Fed. The Fed currently pays banks an interest rate on bank’s holding of excess reserves—deposits banks have with the Fed in excess of what they are required to have. This rate is called the IOER, the interest rate on excess reserves. Under a negative interest rate policy, rather than paying banks interest to hold reserves, the Fed would charge banks interest on reserves held in the form of the deposits with the Fed.
“Would the Fed charge banks interest on the deposits banks are required to hold to meet their statutory reserve requirements?” It could, but banks would likely scream, “You can’t require us to hold deposits with the Fed and then make us pay for the privilege.” But this is a great way to make money: Require someone to do something and charge them for doing it. It seems more likely the Fed would charge banks interest only on excess reserves.
However, this is also problematic. Banks have historically held modest levels of excess reserves, in the range of $1 to $2 billion. Having banks pay interest on such a trivial amount of reserves would have no effect on interest rates generally. As of January 2018, banks now hold slightly more than $2 trillion in excess reserves. Banks hold massive amounts of excess reserves because the Fed went on a massive bond-buying program commonly referred to as quantitative easing (QE) following Lehman Bros.’ bankruptcy announcement on September 15, 2008. Requiring banks to pay for the privilege of holding such a massive amount of deposits with the Fed would have a much more significant effect.
However, banks are forced to hold large amounts of excess reserves just as much as they are forced to hold required reserves. Holding large amounts of excess reserves is no more of a “privilege” than holding required reserves. Consequently, banks should be just as indignant. The reason banks are forced to hold excess reserve is when the Fed purchases securities it creates reserves in the form of bank’s deposits with the Fed. Initially, these reserves are all excess reserves. These reserves cannot leave the banking system unless the Fed sells the securities it purchased. Collectively banks can convert excess reserves into required reserves by making loans (or investments). Because the reserve requirement is 10%, banks would have to make over $20 trillion in loans to convert the over $2 trillion in excess reserves into required reserves. The national debt is currently $20 trillion, so I think we can agree this is next to impossible.
However, banks have tried. Because of banks’ lending, total checkable deposits have increased by $1.5 trillion from August 2008 to January 2018. Consequently, required reserves have increased from $44 billion to $293 billion over the same period. At this rate the current holdings of excess reserves will be eliminated in about 130 years. Hopefully, the FOMC will decide to “normalize” its balance sheet before then. But that may never happen. Ben Bernanke and others have suggested the Fed should keep a large balance sheet indefinitely. I pointed out here why this is a bad idea. The former Fed Chairman doesn’t appear to understand the effect of the large balance sheet on the money supply.
Of course, banks have another option. They could hold the $2 trillion in excess reserves in cash. The problem with this option is that currency in circulation is only $1.6 trillion, which includes a large amount that is overseas. If banks decided to do this, the Bureau of Engraving and Printing (BEP), which prints U.S. currency, would be very busy. The BEP wouldn’t be able to produce this much cash quickly even if it printed only $100s. But the BEP needn’t worry; banks probably don’t have sufficient vault capacity to store this much currency.
In any event, requiring banks to pay interest on large deposits with the Fed will cause some short-term nominal interest rates to be negative for several reasons. Banks would have an incentive to make any loan or investment that pays a negative rate higher than the rate they pay the Fed. For example, if the Fed charges banks 50 basis points per annum to hold excess reserves, banks will have an incentive to make any loan or investment that pays a risk-adjusted interest rate higher than -50 basis points. Like Fed deposits, Treasuries are default-risk free. Consequently, banks would have a strong incentive to purchase short-term Treasuries that pay a negative rate higher than the rate the Fed charges. Banks also would have a strong incentive to pass along some of their increased costs to their depositors, especially large depositors. Interbank lending rates will become negative, too. Hence, they will reduce their lending rates and, most likely, their lending standards. These actions may push other short-term nominal rates negative.
The extent to which the policy would affect private lending rates, especially private long-term rates is questionable. The Fed increased its holdings of securities by $3.7 trillion between September 11, 2008, and October 29, 2014, when it ended its bond-buying program. But QE had no appreciable effect on long-term Treasury or private securities (see show me your evidence). A negative interest rate policy also may have little or no effect on long-term rates.
A negative nominal interest rate policy is a bad idea. It is ridiculous to lend money at a negative nominal rate. No one would do this unless they had no better option. It’s sad that a government-created entity, whose job it is to work in the public interest, would engage in a policy that would force anyone to lend on such terms. Policymakers rationalize the policy claiming lower interest rates increase spending, output, and employment. They assert that a negative interest rate policy will force interest rates lower and result in an increase in output and employment which will more than offset the negative effects of the policy. But such assertions are at odds with logic and the facts (Why the Fed's Policy Failed). A negative nominal interest rate policy will be ineffective for exactly the same reason QE and forward guidance were ineffective.
Moreover, it seems to me that if policymakers have pursued a policy that has driven nominal interest rates to be zero and they find it’s not working (I’m sure this is what they’ll find if they are honest, see my previous essay, here), they should do something else. They shouldn’t pursue a negative nominal interest rate policy in the hope that if interest rates are just a little lower the policy will work. In what alternative world do you have to live to accept such logic? Negative nominal interest rates may work well in economic models that many economists use. But these models are extremely simple relative to the enormous complexity of the real economy. Economic models sometimes provide useful insights, but they should not be used to make real-world monetary policy.
In 1969 Milton Friedman recommended the Fed pay banks interest on required reserves (but not excess reserves) to eliminate inefficiencies caused by the “reserve tax” banks had to pay because they were forced to hold non-interest-bearing reserves to meet Federal Reserve-imposed reserve requirements. Instead, the Fed decided to pay banks interest on bank’s holdings of both excess and required reserves. At some future date, the FOMC may adopt a negative interest rate policy that produces, not fixes, inefficiencies. Policymakers have come a long way since 1969. Unfortunately, they’ve gone the wrong direction.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.