Deeply Negative Interest Rates

Updated February 2021

With the Federal Reserve pretty much emptying its inventory of monetary policy tools when it did this:

...and with the economy needing continuous intervention to prevent an even deeper and longer economic contraction(s), it looks like the Fed will have to use hitherto untested and experimental monetary medicine to get the economy back on its feet once the COVID-19 panic is over and as part of a move to force us into a cashless society.

Thanks to the International Monetary Fund, the braintrust at the Federal Reserve has a roadmap for its future stimulation policies.  Back in April 2019, authors Ruchir Agarwal and Miles Kimball released a working paper entitled "Enabling Deep Negative Rates to Fight Recessions: A Guide" as shown here: 

In this paper, the authors open by noting that a lower bound (i.e. zero percent interest aka the zero lower bound or ZLB) can be a significant obstacle to fighting recessions.  This is particularly the case in our current ultra low interest rate environment which has left the Federal Reserve with almost no room to manoeuvre.  The authors note that the zero lower bound is "...not a nature of law; it is a policy choice..." and that deeply negative interest rates are one tool that can be used by central banks to end recessions in a short period of time. In the authors' opinion, this is preferable to using mildly negative interest rates for a short period of time which may result in a longer period of economic recovery.

In the past, the Federal Reserve and other influential central banks including the Bank of Japan, the Bank of England and the European Central Bank have been able to cut interest rates significantly during economic contractions as shown on this graphic:

On average, central banks have been able to cut interest rates by between 5 percentage points and 6 percentage points during recessions as you can see on this graph showing the Federal Funds Rate going back to 1955:

Clearly, this is no longer possible with the world's key central banks having interest rates that are nearly zero (or less) at this point in time.

As it stands now, the public obtains cash from a commercial bank using an ATM or by cashing cheques.   Commercial banks get their cash from the central bank through an account that they hold on reserve with the central bank by using the central bank's "cash window".  This cash window allows the banks to exchange electronic currency for paper currency which is shipped from the central bank's cash offices.  In the current system, the central bank treats a 100-dollar note as an equivalent to 100-electronic dollars and does not charge any substantial fees for the issuance or acceptance of paper currency (i.e. a zero percent interest rate on currency).  The authors note that this does not have to be the case; central banks could choose to charge a non-zero paper currency interest rate.

How can central banks impose a deeply negative interest rate policy, noting that electronic money refers to credit balances in an account held in the books of the central bank or commercial bank?  There are two methods:

1.) "The Clean Approach" - an electronic money system that takes paper currency off par with electronic money.  For example, using this mechanism, if the central bank wished to implement a negative interest rate policy, it could do so as follows:

"...the central bank could gradually phase out $100 bills by every year deducting $1 from what it would give in exchange for a $100 bill: after one year, $99, after two years, $98 and so on. If that is how the central bank treated a paper $100 bill at the cash window, that is what it would be worth..."(i.e. the central bank would be lowering the value of a paper bill when compared to an electronic dollar, essentially resulting in a negative interest rate).

In this scenario, retailers who accept both cash and credit cards could apply a paper currency surcharge to any transactions where customers use cash.  The advantage to this system is that no extra regulations are required since the impact on the economy works entirely thought the price system by imposing a negative rate of return on paper currency anywhere since it cash is only accepted at a discount.

2.) "The Rental Fee Approach" - an approach which keeps paper currency at par with electronic money within the financial system and the large corporate sector.  The central bank could generate a non-zero paper currency interest rate through the imposition of an "x" percent per annual rental fee for commercial banks withdrawing paper currency from the cash window.  For example, if a commercial bank withdrew a $100 bank note from the central bank, in addition to being debited the $100 from its reserve account by the central bank, it would also pay "x" dollars as a yearly rental fee to the central bank, thus creating a negative interest rate on cash.  To avoid inconveniencing households, the central bank could set an exemption amount which would allow banks to withdraw amounts up to the net withdrawal of paper currency on behalf of its customers up to a per-customer and per-month limit, thus preventing large scale withdrawals.  Both the Swiss National Bank and the Bank of Japan have adopted somewhat altered versions of this approach.

Here is a table showing the side effects of the rental fee approach:

In both cases, the authors recommend that the transmission of negative paper currency interest rates should fall to the commercial banks since they have far more experience dealing firsthand with customer relations problems than central banks. 

Obviously, there will be a reduction in the circulation of paper currency as a result of these two approaches.  Let's look at a quote from the paper:

"If households can’t readily sell it at a premium, they will have incentives to hoard paper currency, instead of using it as a medium of exchange. This in turn will lead to reduced circulation of paper currency in the system. This could be burdensome and costly for some households and small businesses, especially for those that rely heavily on cash transactions. On the other hand, a silver lining of reduced circulation of paper currency would be that it encourages electronic transactions and the adoption of technology that facilitates electronic transactions. By raising the fraction of electronic transactions—and encouraging irreversible investments in digital payment systems—the Gresham’s Law effect would make it easier for the central bank to use the clean approach based on an electronic unit of account at a later date.

Another silver lining of the Gresham’s Law effect would be making law enforcement easier. While many individuals use paper currency for perfectly legal purposes (and some may even have an ‘irrational’ preference for cash), an important part of the demand for paper currency is driven by the desire to keep secrets from the government. As Ken Rogoff (2016) puts it, in addition to the legal tax- paying domestic economy, the sources of demand for cash include the (a) not-so-law-abiding domestic underground economy—including both tax evasion and criminal activities, and (b) the global economy, including both legal and illegal demand.  Imposing a rental fee on cash withdrawals does.  Imposing a rental fee on cash withdrawals does not eliminate the freedom to use cash, but makes large-scale murky cash withdrawals stand out more, thereby facilitating law enforcement." (my bold)

Let's close with these thoughts from the authors:

"Our view is that, when needed, deep negative rates are likely to be worth the political cost. After all, when facing a deep recession with little room to cut rates in the positive region, the choice is not between political calm for a central bank or a political storm for the central bank, but the political cost of negative rates on one hand weighed on the other hand against the opprobrium a central bank justifiably comes under when it fails to fulfil its mandate and return the economy to normal in a timely way. Nevertheless, reducing political costs where that is consistent with sweeping away any lower bound on interest rates is not only directly helpful, but also makes the financial markets more likely to believe that the central bank will be bold enough to pursue a vigorous negative interest rate policy."

Given that the Federal Reserve has dropped its key rate to near zero and further bloated its already morbidly obese balance sheet as shown here:

...we can pretty much assure ourselves that, at the very least, a negative interest rate environment is not far off, particularly as part of the ultimate cashless society scheme currently being explored by central banks around the globe.  As yet, there has not been any experience with interest rates below -1 percent, however, given the current moribund state of the global economy, that is not likely to hold true for very long.

The Federal Reserve's Next Negative Move

Updated April 29, 2020

With the Federal Reserve having now blown its entire traditional monetary ammunition by doing this:

....and further bloating its already "obese" balance sheet as shown here:

...all in the name of battling a pandemic, the world's most influential central bank has little/no room to manoeuvre when the next economic contraction takes place without the use of what could prove to be an extremely painful dose of monetary medicine.

A paper by Andrew Lilley and Kenneth Rogoff at the Harvard University Department of Economics is particularly pertinent in these novel times.  The paper looks at the impact and changes that are necessary to implement an unconstrained negative interest rate policy as a solution to the near-zero effective lower bound and note that this scenario is likely to occur either during the next deep economic contraction or in the event of another financial crisis.  While negative interest rates have been used in Europe and Japan, these rates have only been very mildly negative.  What the authors are examining is the implementation of an unconstrained, deeply negative interest rate policy of at least two percentage points or more.

Here is an opening quote:

"Implementing effective negative rate policy will require a host of legal, regulatory and tax changes.  A considerable amount of time and study is warranted, and the obstacles in different countries may vary. It is notable, however, that most of the changes were navigated fairly smoothly in countries that have implemented mild negative rate policy, albeit no country has tackled the main challenge, which is how to prevent paper currency hoarding and, as a corollary, how to protect bank profitability if rates go deeply negative. In this sense, the kind of unconstrained negative rate policy analyzed here is a very different animal from the very mild and highly-constrained negative rate policy that has been implemented to date." (my bold)

As the authors note, one of the key problems with a negative interest rate policy is hoarding of paper currency.  We can think of it this way; if you invest your hard-earned money with a bank in a negative interest rate environment, you will get less money back once the investment matures.  This will lead people to hoard paper currency since it will not lose value at least as it stands now.  That said, one can imagine the amount of cash hoarding that could potentially take place by financial institutions, pension funds and insurance companies. It is this cash hoarding that could prove to be extremely problematic.

The authors have solutions to the "hoarding option" which is more likely to occur at interest rates lower than -2 percent:

1.) implementing a dual currency system where electronic currency becomes the unit of account which is pegged to the paper currency.  By doing this, private banks will be able to pass on negative rates to larger-scale depositors and shield those retail depositors who have only small bank balances. This will have the added benefit of protecting bank profit margins and prevent a run on physical currency.

2.) phasing out large-denomination notes which the authors believe are generally used to fuel the underground economy.  In this paper, the authors consider large denomination notes to be those that are $50 and above.

3.) taxing of cash would be required for rates lower than -2.5 percent to -3.0 percent.  When interest rates are zero or positive, the exchange rate between electronic currency and paper currency is one to one.  As interest rates drop into negative territory, central banks could adopt a policy where people turning in paper currency after 3 months will receive 99 cents worth of electronic currency, after six months receive 98 cents, after nine months receive 97 cents etcetera.

Another scheme for preventing cash hoarding is to use the serial numbers on paper currency in an expiry scheme.  For instance, in one month, all notes ending with a "0" could be deemed valueless, the following month, all notes ending with "1" could be deemed valueless.  This would force paper currency holders to redeem all of their inventory of bank notes before they became valueless. 

The authors note that, while many would regard negative interest rates are an unfair tax on savers, they believe that negative interest rates make no greater impact on savings than inflation.  As well,  the authors also state that savers would benefit as negative interest rates boost the value of assets such as housing and stocks.  To protect small savers, governments could allow citizens to register one account as eligible for zero interest rate protection.

While it may seem out of the realm of reality, the markets believe that there is a probability that negative interest rates will occur.  In the New York Federal Reserve Bank's Survey of Market Participants dated March 2019, 11 percent of market participants believed that the target fed funds rate  would be negative by the end of 2020 and 17 percent believed that there would be a negative target federal funds rate by the end of 2021 as shown here:

Let's close with this quote from the paper:

"Though many may disagree with our prescriptions, it is worth noting that even in the United States, both market pricing and survey data attribute material probabilities to nominal interest rates moving into negative territory in the near future – and yet they hold these beliefs without an agreed framework for how they would be implemented….

The biggest drawback to unconstrained negative rate policy is that it has not really been tried anywhere, and unintended consequences are possible. But in a deep finanial crisis, countries must often choose from a menu of difficult options, and after decade after the financial crisis, it is clear that none of the other options for restoring monetary policy effectiveness are particularly attractive or sustainable. As we have noted at the outset, the case for considering how to make unconstrained negative rate policy effective is stronger at present in Europe than the United States, and stronger still in Japan. In our view, it is quite likely that some advanced country central banks will experiment with unconstrained negative rate policy during a deep recession within the next decade. The United States is not the obvious first mover. However, given the steady downward drift in global real interest rates, the difficulties in raising expected inflation, the apparent ineffectiveness of quasi-fiscal instruments at the zero bound, and ultimately the importance to central bank independence of having an instrument that the Fed “owns”, creates a strong imperative for proactively preparing now for a negative interest rate world that is perhaps inevitable." (my bolds)

This research by Lilley and Roghoff flies in the face of the interest rate reality that most of us have dealt with our entire lives.  Given that the authors believe that interest rate policies implemented by central banks are far more effective than other monetary policies like asset purchases (i.e. quantitative easing) and forward guidance, it is quite likely that central banks, particularly the Federal Reserve, will have no choice but to implement an unconstrained, deeply negative interest rate policy at some point in the future.

May you live in unique times.

Ben Bernanke on Negative Interest Rates

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.   

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.