Former Fed Chair Narayana Kocherlakota wants the Fed to take rates negative by 0.25% at its next meeting.
Apparently a quarter-point rate reduction in short-term interest rates is going to stimulate growth.
What Mr. Kocherlakota’s model seems to be missing is that negative rates will destroy a multi-trillion dollar money market industry, hurt banks when you need them to lend to stimulate growth, and encourage Americans and American banks to hold money in cash. Mr. Kocherlakota nods to some of these problems, but he likely underestimates America’s financial innovation and “Don’t Tread on Me” attitude. You can count on our experience differing from the Japanese and the Europeans experience with negative rates, which by the way has not been positive.
He writes at Bloomberg:
When Fed officials hold their regular policy-making meeting next week, all the lights on their dashboard will be flashing red. The unemployment rate is expected to reach double digits by June. With global demand cratering, the Fed’s preferred measure of inflation will likely fall to 1% or even lower by the end of the year — well below its target of 2%. And in the absence of a Covid-19 vaccine, the malaise will likely persist well into 2021.
Any Economics 101 student knows that in such a dire situation, the central bank should cut interest rates to stimulate growth and job creation. But as Chair Jerome Powell reiterated last month, the Fed doesn’t plan to do so in the foreseeable future, because a further quarter-percentage-point cut would drive the interest rate it pays on banks’ reserve deposits into negative territory.
Why the fear of negative rates? A decade ago, the answer would have been that it was impossible to go below zero: Banks would simply avoid the charges by withdrawing their reserve deposits and holding the funds in paper currency, which pays zero interest. But economists now recognize that doesn’t happen, because it’s costly to store billions (or trillions) of dollars of paper currency safely. Several European central banks, as well as the Bank of Japan, have successfully taken interest rates below zero. 1 This stimulates consumer demand in the usual ways: by incentivizing banks to make loans at lower interest rates, to bid up the prices of financial assets, and to charge higher fees for deposits.
Another of the Fed’s concerns about negative rates has to do with financial stability — a relatively new (and completely made up) responsibility of central banks. Sure, negative interest rates would help lower the unemployment rate from what is likely to be its highest level since World War II. But officials worry that they will also weigh on banks’ profitability, pushing down share prices and making the financial system more vulnerable to distress. Put crudely, the Fed is giving up on unemployment reductions to help keep banks and their shareholders safer.
The Fed is inventing a trade-off where none exists. If the central bank really cares about financial stability, it has many tools to ensure it. Right now, for example, it could block large banks from paying dividends, a practice that erodes the capital they need to absorb losses. None of this precludes a monetary policy focused on the Fed’s congressional mandate of maximizing employment and keeping inflation near target.
Read more here.