What a Thrill! Just Don’t Think About the Impact
It seems clear to everyone that economies are not doing as well as hoped, and that the global recovery is not as strong as politicians and central bankers expected it would be by now. In fact, the recent rate hike by the U.S. Federal Reserve is already termed by many experts as a mistake or misunderstanding of the underlying data. For those critics, the next step can only be to implement helicopter money and/or negative interest rates. In general, the assumption of many seems to be that when the economy’s engine is not roaring loud enough it is the Fed’s obligation to provide some sort of monetary fuel. This is the base of many arguments, especially by financial market commentators. But can monetary policy actually affect the current causes of the slow-down? And even if it can, should central banks really implement (further) negative rates?
You almost could start this paragraph with ‘Once upon a time’, because it seems to me that it’s been ages since there was a greater understanding that the main objectives for the Fed, under the Federal Reserve Act, are maximum employment, price stability, and moderate long-term interest rates. As shown in Figure 1, inflation (the main indicator of price stability) has long been lower than the desired level of 2 percent[i], and many market commentators have used low inflation as a reason to call for additional monetary easing to animate the demand side—giving the economy its needed push.
Figure 1: U.S. Inflation 2005—2015
The argument goes that through some additional monetary easing, such as negative interest rates, financial institutions will create new credit that will lead to productive economic endeavors and finally make America great again. However, the evidence supporting the idea that negative interest rates on the banks’ reserves held by the Fed will function as economic fuel is not convincing, judging by the European Central Bank’s economic development since its foray into negative rates. The first negative rate was set at -0.10 percent in July 2014 but since then has reached -0.40 percent[ii], with the assurances from Mario Draghi that there are no limits.[iii] Even with these pushes to reduce market borrowing costs and encourage lending, the European situation is not doing so well, undercutting the buzz about the promise of negative rates.
In a world of new money what was considered a safe haven—storing money with central banks—will come with a hefty charge. German treasury bonds will lose money no matter what, and already weak and vulnerable banks will take a hit on their profitability as they have to cope with the additional reserve expenses. This makes the proposal of negative interest rates as an economic boost less compelling. Negative interest rates are supposed to encourage banks to lend more money, but with supply side measures so far having done little other than to raise demand for riskier financial instruments it is hard to see this going anywhere for the real economy. Given the scant evidence and uncertainty of the effect of negative rates it does not seem prudent to venture into negative interest rate policy without serious further research and analysis.
We should also keep in mind that the current low level of inflation is mostly due to the levels of commodity and import prices. The former is due to competition among the world’s oil suppliers, who, while struggling, do not seem to be able to come to an agreement. The latter is driven by the dollar’s recent strength, with import prices to the U.S. showing a steep decline—falling over the past year by 12.6% for Canada and 3.9% for Mexico.[iv] In addition, China is suffering from the result of overinvestment into key sectors after the financial crisis. This has led to an enormous rise in production capacity, which is spilling over to global markets and weakening prices. One form of these spillovers is the tariff back-and-forth between China and the U.S. triggered by accusation of dumping.[v] All this adds to doubt about the efficacy of negative interest rates as boosters for the U.S. economy—and about domestic demand being the savior.
In summary, as my colleague Keith Savard already noted in his recent blog, it might be the time for central bankers to take a step back and return to their pre-crisis long-term approach, thereby giving space to other policymakers that actually have the right tools and mandate. Negative rates seem to have very little helpful effect besides stripping central banks of their policy instruments and creating a race-to-the-bottom environment.[vi] Keep in mind that no one understands the dynamics of negative rates, which leads to questions about how this might backfire and possibly result in an episode of systemic risk. To paraphrase Milton Friedman: Fine tuning is a marvelously evocative phrase, but it has little resemblance to what is possible in practice. [vii],[viii]
[ii] January 2016.
[v] U.S. tariffs on Chinese steel are just the latest example: http://www.wsj.com/articles/u-s-imposes-266-duty-on-some-chinese-steel-imports-1456878180
[vi] The discussion about negative interest rates comes with the taste of currency wars, as one can already see in the current press.
[viii] Ironic enough Milton Friedman also introduced the idea of helicopter money, but his assumption was that it be a unique event, a doubtful assumption given central bankers track record.