Negative Interest Rates - How Low Could They Go?

A speech given by Janet Yellen at the Jackson Hole, Wyoming "Designing Resilient Monetary Policy Frameworks for the Future" provides us with a glimpse into how the Federal Reserve will tackle the next recession.

Let's start with this quote:

"My focus today will be the policy tools that are needed to ensure that we have a resilient monetary policy framework. In particular, I will focus on whether our existing tools are adequate to respond to future economic downturns. As I will argue, one lesson from the crisis is that our pre-crisis toolkit was inadequate to address the range of economic circumstances that we faced. Looking ahead, we will likely need to retain many of the monetary policy tools that were developed to promote recovery from the crisis. In addition, policymakers inside and outside the Fed may wish at some point to consider additional options to secure a strong and resilient economy."


In her speech, Ms. Yellen notes that the FOMC expects moderate real growth in GDP and that inflation will rise to 2 percent over the next few years.  Despite the Fed's best efforts, as you can see on this graph, inflation as measured using Personal Consumption Expenditures (PCE) remains uncomfortably below the Fed's target:

The last time the year-over-year increase in PCE was in excess of 2 percent was back in early 2012 when it hit 2.1 percent for a very short time.

Now that we've looked at the inflation conundrum, let's look at another quote from Ms. Yellen's speech:

"And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight. For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide..."  

In fact, here's how wide the  70 percent probability projections for the federal funds rate are with the median pathway shown as a dark line:

That's a spread of 4.5 percentage points between the low and high estimates by the time we get out to the end of 2018.  I guess that allows the FOMC to cover themselves for just about any contingency!

Now, let's look at Ms. Yellen's comments on the Federal Reserve's toolkit prior to the Great Recession

"Prior to the financial crisis, the Federal Reserve's monetary policy toolkit was simple but effective in the circumstances that then prevailed. Our main tool consisted of open market operations to manage the amount of reserve balances available to the banking sector.  These operations, in turn, influenced the interest rate in the federal funds market, where banks experiencing reserve shortfalls could borrow from banks with excess reserves. Before the onset of the crisis, the volume of reserves was generally small--only about $45 billion or so.  Thus, even small open market operations could have a significant effect on the federal funds rate. Changes in the federal funds rate would then be transmitted to other short-term interest rates, affecting longer-term interest rates and overall financial conditions and hence inflation and economic activity. This simple, light-touch system allowed the Federal Reserve to operate with a relatively small balance sheet--less than $1 trillion before the crisis--the size of which was largely determined by the need to supply enough U.S. currency to meet demand."

The problem with this "simple monetary policy toolkit" was that it meant that the Fed could no longer control the federal funds rate when bank reserves were no longer scarce, largely because banks simply weren't lending.  This meant that the Federal Reserve had to create programs that would keep credit flowing to both households and Corporate America.  Even with those actions, bank reserves still kept growing, resulting in the Fed nearly losing control over its own interest rate policies.  This meant that the Federal Reserve had to lower the target for the federal funds rate to near zero where it has been ever since, a drop of five percentage points over its previous level as you can see on this graph:

Now, let's look at the most interesting comments of the speech:

"Nonetheless, a variety of policy benchmarks would, at least in hindsight, have called for pushing the federal funds rate well below zero during the economic downturn.  That doing so was impossible highlights the second serious limitation of our pre-crisis policy toolkit: its inability to generate substantially more accommodation than could be provided by a near-zero federal funds rate."

Let me repeat that; if the Fed had only used its traditional influence over the federal funds rate to prop up the economy, it would have had to push interest rates well below zero.

It's at this point that readers of Ms. Yellen's speech have to note the small "8" that comes after the highlighted sentence.  It refers to a note which is attached to the bottom of the speech as quoted here (and please pardon the inclusion of the policy rule equation and focus on the highlighted portion):

"Consider the following policy rule: R(t) = R* + p(t) + 0.5[p(t)-p*]-2.0[U(t)-U*], where R is the federal funds rate, R* is the longer-run normal value of the federal funds rate adjusted for inflation, p is the four-quarter moving average of core PCE inflation, p* is the FOMC's target for inflation (2 percent), U is the unemployment rate, and U* is the longer-run normal rate of unemployment. Based on the medians of FOMC participants' latest longer-run projections, R* is approximately 1 percent and U* is about 4.8 percent. Accordingly, with the unemployment rate climbing to 10 percent and core PCE inflation falling to 1 percent in 2009, this rule would have prescribed lowering the federal funds rate to minus 9 percent at the depths of the recession. In contrast, the standard Taylor rule, which is half as responsive to movements in resource utilization, would have prescribed lowering the federal funds rate to minus 3-3/4 percent using the same estimates for R* and U*."  

Basically, what Ms. Yellen is telling us is that, without the creative use of quantitative easing and other non-traditional monetary policies like forward guidance and "The Twist", the Federal Reserve would have been powerless to breathe life back into the near-dead economy unless interest rates had dropped to between -3.75 and -9 percent!

Let's close this posting with an observation; given that several of the world's influential central banks, most particularly Japan, have had to resort to the use of negative interest rates in a last ditch effort to restart their sluggish economies and spark some inflation and with the added complication of a lethargic global and American economy, the Federal Reserve will have to be even more creative during the next recession since their non-traditional policies have been less than spectacularly successful since 2008.  My guess is that negative interest rates are sure to appear on this side of the Atlantic and Pacific Oceans since they seem to be the current choice of desperate and monetarily cornered central bankers and Ms. Yellen's speech shows us that the Fed is at least considering the potential impact of negative rates on the American economy.