The Ghost of Ben Bernanke

You may think that Ben Bernanke, architect of the Federal Reserve's $4.5 trillion balance sheet, had faded into obscurity, but he's still alive and well and blogging on the Brookings Institute website that you can find here.  In a recent posting, he looks at the Federal Reserve's monetary toolkit and what ammunition it has left, particularly negative interest rates and their potential impact on the economy.  Here are the highlights.

Mr. Bernanke opens by noting that the U.S. economy is growing and creating jobs (no doubt, thanks to trillions of dollars worth of untested monetary policy experimentation), however, he notes that there is a "possibility" that the economy will "slow, perhaps significantly".  At that suggestion, he asks "What tools remain in the (Federal Reserve's) toolbox?".  That, indeed, is a very good question considering that the Fed has used three rounds of quantitative easing, the Twist and forward guidance to prod the reluctant economy back to life.  In this posting, he discusses the implementation of a negative interest rate policy, an as yet untried policy at least on this side of the Atlantic and Pacific Oceans.

Mr. Bernanke goes on to state the obvious:

"Given where we are today, how would the Fed respond to a hypothetical economic slowdown? Presumably the central bank’s first response, after dropping any plans to raise rates further, would be to cut short-term interest rates, perhaps to zero. Unfortunately, with the fed funds rate (the Fed’s target short-term rate) now between ¼ and ½ percent, and likely to remain relatively low, moving to zero provides much less firepower than in the past. For comparison, the Federal Open Market Committee (FOMC), the Fed’s monetary policy-making body, cut the short-term interest rate by 6.8 percentage points in the 1990-91 recession and its aftermath, by 5.5 percentage points in the 2001 recession, and by 5.1 percentage points at the beginning of the Great Recession in 2007-2008." (my bold)

He suggests the following solutions to the Federal Reserve's "painting itself into its current policy corner":

1.) Further Forward Guidance: The Federal Reserve could communicate to the markets and the public that short term rates will stay low for a much longer period of time.  This could allow long-term rates for such things as mortgages to drop closer to short-term rates although the outcome is far from certain.

2.) Further Quantitative Easing: By purchasing additional long-term assets for the Fed's already bloated portfolio, additional reserves are created in the banking system.  This would encourage borrowing and spending.  Let's see how well the unprecedented and highly experimental $3.6 trillion worth of QE did for mortgage borrowers since the beginning of the Great Recession:

Mortgage debt is down from its 2008 high of $14.8 trillion to its current level of $13.8 trillion after hitting a low of $13.2 trillion in early 2013.  So much for encouraging the banking system to lend to homeowners.  Obviously, further QE will be like pushing on a string.

3.) Negative Interest Rates:  Negative interest rates are the new buzzword among central bankers around the globe and have been implemented by the Bank of Japan, the ECB and a handful of European national central banks as well as being threatened by both the Federal Reserve and the Bank of Canada.  In the negative interest rate scenario, the banking system is charged interest on the reserves that they hold at their local central bank.  To minimize the impact of these fees on their bottom lines, the banking system will reduce their holdings at central banks and invest in other short-term assets that will drive the yields on short-term investments into negative territory as well as driving down the yields on longer term securities that have an impact on mortgage and business loans.  While this sounds like a great deal, let's see what has happened to the excess reserves that the American banking system has stockpiled at the Federal Reserve since the Fed started actually paying banks 0.50 percent to store their "money":

    

At $2.36 trillion, the American banking system is doing exactly the opposite of what the Fed needs it to do to get the economy borrowing and spending.

Mr. Bernanke goes on to explain why we should not be afraid of negative interest rates.  He notes that economists are accustomed to dealing with negative real interest rates (interest rates that have been corrected for inflation) as we can see on this graph which shows a 60 year history of the real effective Federal Funds Rate:

As you can see, for most of the period up to the Great Recession, the Federal Reserve had substantial monetary headroom to lower nominal interest rates during recessions.  This changed in 2008 as the Fed pushed nominal interest rates to the zero lower bound, totally removing any hope that they could lower interest rates further...unless, of course, they lowered nominal rates into negative territory.

Mr. Bernanke then explains the practical issues behind lowering interest rates into negative territory:

1.) Does the Fed have the authority to impose negative interest rates on the reserves that banks hold with it?  According to the Act which governs the Federal Reserve's operations, the Fed's fees must reflect the actual cost of providing the service over the long-run.  Since the cost of holding bank's reserves is low, it may not be legal for the Fed to charge banks for holding their reserves.

2.) How negative should rates go?  When rates become excessively low and punitive, Mr. Bernanke shows some contact with the real world by noting that consumers will simply hold/hoard currency.  Banks could profit by holding customers' cash for a fee or (and this is a big or), cash could be abolished or have an expiry date linked to its serial number.  Federal Reserve research shows that the interest rate paid on bank reserves in the United States could not be lower than -0.35 percent, however, rates in Europe are as now as low as -0.75 percent and there has been no sign of currency hoarding.  I'd add that this is likely because cash is becoming increasingly less utilized in some nations across Europe that have implemented negative rates.

3.) The effect on money market funds (MMF) could be problematic given that MMF investors have traditionally been promised that they can withdraw at least the full amount that they have invested because MMFs are widely regarded as completely risk-free.  When investors do not get their entire investment back, as very nearly occurred in 2008, it is termed "breaking the buck".  Implementing a negative interest rate policy could alter the MMF landscape, reducing an important source of short-term funding for the financial industry.

4.) The effect on the profits of the banking sector could be substantial if banks do not pass along negative interest rates to their customer base.  I suspect that this is highly unlikely to be a problem since banks are very creative when it comes to implementing new fee structures to ensure that their profits remain intact.  As well, Mr. Bernanke notes that interest rate margins would likely continue to remain positive in a negative interest rate environment because interest rates charged on long-term loans such as mortgages would most likely remain in positive territory.

Let's look at Mr. Bernanke's closing comments on negative interest rates:

"Overall, as a tool of monetary policy, negative interest rates appear to have both modest benefits and manageable costs; and I assess the probability that this tool will be used in the U.S. as quite low for the foreseeable future. Nevertheless, it would probably be worthwhile for the Fed to conduct further analysis of this option. We can imagine a hypothetical future situation in which the Fed has cut the fed funds rate to zero and used forward guidance to try to talk down longer-term interest rates. Suppose some additional accommodation is desired, but not enough to justify a new round of quantitative easing, with all its difficulties of calibration and communication. In that scenario, a policy of modestly negative interest rates might be a reasonable compromise between no action and rolling out the big QE gun." (my bold)

In closing, as was pointed out to me, I find two sentences in the second paragraph of his posting rather interesting and a bit puzzling.  Here's sentence one:

"I’ll conclude in these two posts that the Fed is not out of ammunition, and that monetary policy could help cushion a possible future slowdown." (my bold)

Here's the second sentence:

"That said, there are signs that monetary policy in the United States and other industrial countries is reaching its limits, which makes it even more important that the collective response to a slowdown involve other policies—particularly fiscal policy" (my bold)

Does this not sound like a contradiction?  A rather frightening contradiction given that over seven years of Federal Reserve "monetary medicine" has accomplished rather little given the risks that were taken?  The possibility that the Fed will dive further into uncharted monetary territory should give us good reason to ponder the wisdom of today's central bankers.