What if there is no zero bound problem?
By Scott Sumner
It seems as though the major central banks are beginning to rethink their assumptions. Here’s an ECB official:
Monetary policy risks becoming ineffective in a world where growth is sluggish, economies are deeply interconnected and interest rates are already near zero, a top European Central Bank policy maker said on Saturday.
Speaking at the University of California Berkeley, ECB executive board member Benoit Coeure called for academics and policy makers to address issues at the root of a global economic malaise, singling out the euro zone’s inability to revive domestic demand.
“The capacity of the global economy to generate growth is under question,” Coeure said in remarks prepared for a speech.
“In a global zero lower bound environment, surplus countries hold world output down.”
But then why did the ECB raise rates twice in 2011? And here’s a top Fed official:
The U.S. Federal Reserve and other global central banks may need to consider new tools in a world of permanently lower interest rates, including keeping big balance sheets or using negative interest rates to combat shocks, a top Fed official said on Saturday.
With the so-called natural interest rate in the United States now near zero, and equilibrium rates in other countries around the world also lower than in the past, central banks have “significantly less room to maneuver” in the face of recessions, San Francisco Fed President John Williams said at a conference at University of California Berkeley’s Clausen Center.
Everyone seems to assume that the zero lower bound is the key problem. But how do we know this? Has the lower bound ever been tested? Not as far as I know.
In standard new Keynesian models, bank reserves and Treasury securities become almost perfect substitutes at the zero bound. And the key assumption is that it’s not possible to pay negative interest on bank reserves. Except that it is possible, indeed it’s been done.
When economists are confronted with this fact, they point out that commercial bank deposits at the Fed and vault cash are near perfect substitutes, and thus negative interest on reserves would merely cause the money to move out of the central bank and into vault cash. However this doesn’t really resolve the issue, as it’s certainly technically feasible to pay negative interest on vault cash.
Indeed it’s technically possible to pay strongly negative interest on bank reserves, including vault cash. How negative? There is no lower bound.
When economists are confronted with this fact they suggest that sharply negative interest rates on reserves would depress bank deposit rates so low (so far negative) that the public would pull money out of the banking system, and hold it as currency.
That is certainly true, but the important question is how much? Today, banks in the US hold nearly $3 trillion in reserves; what if all of that went into circulation? How about $10 trillion, or $15 trillion? Maybe nothing would happen, it would all go under mattresses, or into safety deposit boxes. On the other hand maybe it would create a Latin American-style hyperinflation. We simply don’t know. (I bet on hyperinflation, if the currency stock exceeds $10 trillion.)
I understand all this, but here’s what I don’t understand—why the lack of curiosity? You are in a prison cell. The door to your cell might be locked, or it might be unlocked. You don’t know. But wouldn’t you be curious? Wouldn’t you try to open the door to see if you could freely walk out into the sunshine? Or would you just sit there, day after day, year after year, wondering? Is it locked?
The world’s central banks have chosen to just sit there, wondering. They haven’t tried lowering IOR so far negative that all of the bloated base money floods out into cash held by the public. They aren’t curious. Nor are academic economists. Why not?
In 2009 the Fed claimed to be worried about the effect of negative IOR on money market funds. At the time, I argued that that worry was preposterous. Now the Fed seems to have conceded that negative IOR is an option—even Janet Yellen has discussed the possibility. That’s progress. But we still don’t see any central bank fully exploring the possibilities of negative IOR. And that’s a puzzle. Although I suppose it’s no more of a puzzle than the Fed’s reluctance to cut rates to zero in September, October and November 2008. I thought Ben Bernanke’s memoir would resolve that mystery, but all we got was an admission that the Fed had erred in not cutting rates after Lehman failed. Yeah, I’d say so, but why is an institution full of such smart people so obviously inept in a crisis? Another mystery.
HT: TravisV, Dajeeps