Now that the Federal Reserve has made another tentative and infinitesimally small increase in its benchmark interest rate, a blog posting by former Federal Reserve Chairman, Ben Bernanke, takes a fascinating look at what may lie ahead for the Fed, particularly when it comes to negative interest rates, the monetary policy choice-of-the-day for some of the world's most influential central bankers. Let's take a look at the rationale that he uses to defend his position on the use of negative interest rates as part of the Fed's arsenal of monetary weapons.
Firstly, Mr. Bernanke notes the following:
"Nominal interest rates are very low, and in a world of excess global saving, low inflation, and high demand for safe assets like government debt, there’s a good chance that they will be low for a long time. That fact poses a potential problem for the Federal Reserve and other central banks: When the next recession arrives, there may be limited room for the interest-rate cuts that have traditionally been central banks’ primary tool for sustaining employment and keeping inflation near target."
It is this exact "monetary policy corner" that is creating the need for the Federal Reserve to change its modus operandi when it comes to the next recession. Some Fed insiders like John Williams and Eric Rosengren have suggested that the Federal Reserve raise its target for inflation upwards from its current level of 2 percent and suggest that the use of negative interest rates should be a last resort. Here's what Mr. Bernanke has to say about that approach:
"...negative rates and higher inflation targets can be viewed as alternative methods for pushing the real interest rate further below zero. In that context, I am puzzled by the apparently strong preference for a higher inflation target over negative rates, at least based on what we know now. Yes, negative interest rates raise a variety of practical problems, as well as political and communications issues, but so does a higher inflation target. In this post, I argue that it’s premature for policymakers to emphasize the option of raising the inflation target over the use of negative rates. Pending further study about the costs and benefits of both approaches, we should remain agnostic about whether either or both should be part of the Fed’s policy framework."
Mr. Bernanke goes on to observe that the Federal Reserve has routinely set the real federal funds rate at negative levels (i.e. when the nominal federal funds rate is lower than the rate of inflation). Assuming that the Fed will not set the federal funds rate at negative levels, under the current inflation target of 2 percent, the Fed cannot reduce the real policy rate below -2 percent (i.e. a zero nominal rate minus the 2 percent inflation expectation). If the Fed wanted to lower the real federal funds rate further, it would have to lower the nominal federal funds rate into negative territory or raise the inflation target or both. For example, with an inflation target of 4 percent in a zero-percent nominal interest rate environment, the real federal funds rate could be as low as -4 percent. Given that inflation has done this since the beginning of the Great Recession, raising the inflation target is a non-starter:
As such, Mr. Bernanke goes on to provide four reasons why he believes that negative interest rates are preferable to a higher inflation target as follows:
1.) Ease of Implementation: The Bank of Japan and the European Central Bank have imposed a negative interest rate policy and in their experience, the action is instantaneous and spreads rapidly to other interest rates and asset prices. To enforce a negative interest rate policy, the Fed could simply impose an interest rate charge on banks who chose to keep their reserves with America's central bank. In contrast, imposing a higher inflation target would not increase the Fed's ability to lower the real interest rate unless consumers' and corporations' inflation expectations changed as well. Changes in inflation expectations tend to be respond very slowly in prolonged low inflation environments like those that exist today.
2.) Costs and Side Effects: Negative interest rates can cause profitability problems for the banking/financial sector and money market funds, particularly in a long-term negative interest rate environment. This is critical since the successful implementation of central bank monetary policies requires a healthy banking sector. On the other hand, higher inflation can result in financial stability risks including reductions in the value of bond portfolios. This is a particular problem for the financial sector including pensions and insurance companies which have traditionally held long-term bonds as part of their portfolios.
3.) Distributional Effects: An environment of negative interest rates would affect wealthier households and corporations while the financial sector may be less likely to pass on negative rates to small depositors. On the other hand, it would benefit debtors including mortgage holders. A higher inflation environment would be harder on less wealthy households who find it more difficult to shelter themselves from higher costs of living and holders of bonds who would suffer a capital loss.
4.) Political Risks: Both policies would be politically unpopular; Mr. Bernanke notes that this could lead to:
"...reduced support for the policies of the central bank and for its independence. In particular, as already noted, the credibility of a higher inflation target could be reduced if political support for it were seen to be tenuous. Political viability is thus an important concern in judging these policy options."
With the expectation that negative rates would be a short-term phenomenon that is used only during economic emergencies, this approach may be easier for the public and politicians to swallow, however, as Japan and Europe are showing us, negative interest rates show little sign of abating and politicians in both jurisdictions do not seem to be suffering from this recent phenomenon. On the other hand, a higher inflation target would be seen as a long-lasting change that is not restricted to an economic emergency; in this case, approval or review by Congress may be necessary.
With all of this in mind, here is Mr. Bernanke's conclusion:
"It would be extremely helpful if central banks could count on other policymakers, particularly fiscal policymakers, to take on some of the burden of stabilizing the economy during the next recession. Since that can’t be assured, and since the current low-interest-rate environment may persist, there are good reasons for the Fed and other central bankers to consider changes in their policy frameworks. The option of raising the inflation target should be part of that discussion. But, as I have argued in this post, it is premature to rule out alternative or potentially complementary approaches, including the possibility of using negative interest rates." (my bold)
Both negative interest rates and higher inflation targets would give the Fed more room to manoeuvre during future recessions. Obviously, Mr. Bernanke currently favours a negative interest rate policy over an increase in the inflation target as a future means of extricating the Federal Reserve from its current "monetary policy corner". While Ms. Yellen has, so far, been reluctant to implement a negative interest rate policy, as we all know, one should never say "never" when one is a central banker. As the post-Great Recession period has shown us, central bankers are only too willing to fly by the seats of their collective pants when it comes to creative and experimental monetary policy implementation. As well, the Federal Reserve's long policy of ultra-low interest rates have boxed it into a policy corner when it comes to lowering rates to battle future economic downturns.