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Unconstrained Negative Interest Rates - June 4, 2019

“The Most Elegant and Long-Term Solution”

 This week’s snappily titled Conference on Monetary Policy Strategy, Tools, and Communication Practices (A Fed Listens Event) marks the culmination of the Fed’s navel-gazing, er, review of the methods it uses “to pursue the monetary policy goals established by the Congress”. The agenda includes “What Does Full Employment Look Like for Your Community or Constituency?” and “Monetary Policy Strategies”. Many a heavy-hitter will be there, including Jerome Powell and Richard Clarida. For those without the time to wade through the multitude of papers and session summaries, none other than Kenneth Rogoff has presented a good summary of Fed tools in a recent paper authored with Andrew Lilley.

In “The Case for Implementing Effective Negative Interest Rate Policy”, Rogoff and Lilley explore “the case for gradually instituting the changes necessary to implement unconstrained negative interest rate policy” and in the process examine some of the alternatives to the zero bound.

They find “Pure QE”, “where the central bank issues bank reserves to purchase medium and long-term debt”, “is at best a fairly weak instrument that provides no special role for the central bank outside of an extremely short-term crisis management situation”.

“Fiscal QE”, “in which the central bank purchases private sector assets”, “in normal times involves picking winners and losers and is effectively a type of industrial or development policy”. “Most advanced economies regard unelected central bankers aa [sic] ill-suited to making these fundamentally political decisions.” In sum, “fiscal QE is ill-suited as a substitute for conventional monetary policy in normal times”.

Regarding “helicopter money”, Rogoff and Lilley believe it has a place, as “fiscal policy can lift the economy out of the liquidity trap”. However, it is “at best a distraction from finding a serious solution to the zero bound” and they argue that “it is unlikely that money-financed deficits are the panacea many would wish them to be”.

Finally, in the review of Fed tools, Rogoff and Lilley address “forward guidance”. They concede that promises of future inflation overshoots can have “the same effects on the real economy as if negative interest rate policy were possible”. Still, with forward guidance there is always the danger of a credibility problem. Even when inflation targets themselves are changed, the market may not respond appropriately.

“One only has to look at the experience of the Bank of Japan, which set an inflation target of 2% in January 2013 – which by any interpretation constituted a hike in market perceptions of its inflation target, and yet long-term inflation expectation barely moved from its level of 0.5%.”

Beyond the overview of central bank tools used in lieu of deeply negative rates, Rogoff and Lilley’s paper presents an excellent overview of discussions around potential consequences, market expectations, and (following the law of the instrument) a discussion of eliminating cash in a move toward “a negative interest rate world that is perhaps inevitable”.