James McAndrews: Negative nominal central bank policy rates - where
is the lower bound?
Remarks by Mr James McAndrews, Executive Vice President and Director of Research of
the Federal Reserve Bank of New York, at the University of Wisconsin, Madison, 8 May
2015.
* * *
The views expressed in this speech are those of the author and do not necessarily reflect the views of the Federal
Reserve Bank of New York or of the Federal Reserve System.
The Swiss National Bank (SNB), the European Central Bank (ECB), Danmarks Nationalbank
(DNB), and the Swedish Riksbank recently have pushed short-term interest rates to levels
below the "zero lower bound." The current extent and depth of negative policy rates is
unprecedented; previously only Denmark had a modestly negative policy rate in 2012
through 2014. The actions of the four central banks have led a number of commentators to
ask, Is the concept of a zero lower bound on interest rates valid? If not, what might be the
lower bound, if any, on nominal interest rates? Indeed, some economists have suggested
that with changes to the monetary system, we could in fact eliminate the lower bound to
interest rates altogether.
I'll first review the reasons given by the central banks for setting negative policy rates - in all
cases, the negative rates were seen as a means of advancing the banks' macroeconomic
objectives in the current environment. But much of my talk will focus on the unique
complications associated with negative nominal interest rates and the extent to which these
complications constrain how low the rates can be set.
After outlining these challenges, I'll suggest that the zero lower bound on policy interest rates
is much like the low tide mark on a beach: Standing at that border between the land and the
ocean, you can continue to lower your elevation by walking into the water, but with each
additional step, you will need to push against the increasing resistance of the water. There is
a distinct qualitative difference between positive and negative nominal interest rates, just as
there is a distinct qualitative difference between the beach and the ocean. The zero lower
bound is marked by this same qualitative difference: zero is a rate below which a central
bank encounters the distinctive and increasing costs of a negative nominal rate, relative to a
nonnegative rate of interest.
Purpose
In September 2014, the ECB lowered its deposit rate to its current level of negative
0.2 percent. More recently, in late 2014 and early 2015, the SNB, DNB, and Riksbank
reduced their policy rates to levels below zero, with the SNB and DNB setting their rates at
negative 0.75 percent.1 These central banks established their negative rates for various
reasons. Both the SNB and DNB established negative policy rates primarily to deter capital
inflows and reduce the appreciation pressure on their currencies. In the case of the ECB and
the Riksbank, negative policy rates were intended to provide additional monetary
accommodation to ensure price stability over the medium term and a return of inflation to the
central bank objective. Money market rates in the jurisdictions adopting negative deposit
rates have also moved into negative territory, suggesting that the transmission of policy rates
into market rates has continued.
The central banks implement their negative rate regimes in different ways, but in each case
some of the bank reserves on deposit at the central bank are subject to negative rates. In
other words, some commercial banks are charged periodically for (some of) their deposits at
the central bank. In addition, some central banks conduct both overnight and term repo and
reverse repo transactions at negative rates.
In addition to implementing the negative policy rates, each of these central banks has
employed a variety of other tools to support its policy objectives, such as significant foreign
exchange intervention for both the SNB and Danmarks Nationalbank and programs of asset
purchases, or quantitative easing, for the ECB and, in a smaller-scale program, the
Riksbank.
In an important sense, lowering interest rates to reduce capital inflows into a currency or to
provide more accommodative financial conditions is a standard practice of central banking.
Lower interest rates reduce the return to saving for households and reduce the "hurdle rate"
to investment for businesses. Consequently, lower interest rates tend to support both
consumption and investment, and thereby increased aggregate demand. If a central bank
judges that demand is insufficient, and if the interest rate is already at zero, then lowering the
interest rate necessarily means setting a negative rate.
A key dimension of these issues is the distinction between the nominal interest rate and the
real interest rate. The nominal interest rate measures the gross interest rate at which debtors
remunerate creditors. The real interest rate measures the net interest rate at which debtors
remunerate creditors - that is, after subtracting the inflation that is expected to occur over the
period during which the debt is outstanding. It is the real interest rate that is more important
in stimulating or throttling consumption and investment decisions, as economic agents'
income and expenses are affected by inflation more or less equally.
The relationship between the nominal interest rate the real interest rate and the rate
(rN), (rr)
of expected inflation is concisely expressed in the Fisher equation, or r_N=π_ε+r_r. This
(Πe)
relationship reveals that a negative real interest rate does not necessarily require fixing the
nominal interest rate at negative levels. Instead, if expected inflation is positive, then for a
sufficiently low but positive nominal interest rate, the real rate of interest will be negative.
One way to think of this is to liken prices and interest rates to the speed of travel for a person
attempting to ascend a downward-moving escalator. The nominal interest rate can be
thought of as the person's own effort to climb the steps; the rate of inflation can be thought of
as the rate of speed of the escalator itself, descending against the stair climber. If the climber
is ascending as fast as the escalator descends, she makes no vertical progress. This
outcome can be likened to a real interest rate of zero - the nominal rate of interest just
offsets the inflation eroding the value of money. If the climber ascends more slowly than the
escalator descends, the outcome is analogous to a negative real interest rate. If the escalator
stops for some reason, then the only way to have a negative real interest rate is for the
climber to descend by climbing down the escalator - a negative nominal rate of interest.
It is not uncommon for countries to experience negative real interest rates. When nominal
interest rates are positive, but real rates are negative, conditions are "conventional" in the
sense that the debtor still pays positive gross amounts of interest to creditors. So the
innovation in the negative nominal policy rates we see at Danmarks Nationalbank, the ECB,
the Riksbank and the SNB is in the "nominal" aspect of their policy. It is unusual to set
nominal policy rates at negative levels. When nominal rates are negative, creditors pay
debtors interest, and debtors earn interest on their debt. That is, instead of your money
working for you, you have to work for your money.
To explain why we are seeing these negative nominal rates, we can invoke the Fisher
equation. In Denmark, Sweden, Switzerland and the euro area, rates of inflation, and
expected inflation, had been falling and were near zero. Other things equal, the resulting real
interest rates were too high for comfort. In an environment of low inflation, one policy to
reduce real interest rates would be to boost expected inflation. However, there may be few or
no easy ways to raise those expectations quickly; policies such as quantitative easing may
take time to implement and have complications of their own. An alternative approach to
reducing the real interest rate, the Fisher equation suggests, is for the central bank to set a
negative nominal rate.
In addition to this straightforward influence of negative nominal rates on real rates, setting
negative nominal rates may stimulate the economy in less predictable and clear ways. For
example, setting a negative nominal policy rate - a move that is, by nature, unconventional -
may surprise people and thereby send a strong signal of the central bank's intent to pursue
its policy objective. Such a signaling channel may reinforce the effect of the negative rate
and have an independent effect on boosting inflation expectations.
Lowering the policy rate into negative territory can also be useful in reducing the pressure on
an appreciating currency. If a country's currency is facing such appreciation pressures at a
time when "substitute" currencies have policy rates at or near zero, then the country's central
bank may choose to move its policy rates into negative territory to reduce the yields available
to market participants who are holding the currency in anticipation of a gain on sale.
Complications
I'll now outline seven categories of complications associated with negative nominal policy
rates. While some of these complications are already relevant in an environment of low real
rates of interest, most arise only when nominal rates turn negative.
1. Avoidance
Why do people say there is a lower bound on interest rates at zero? Our simple proposition
is that people would not invest a dollar in an account or bond from which they could expect to
recoup only an amount less than a dollar so long as they could alternatively and costlessly
put their money in currency - an investment in which a dollar remains a dollar. If everyone
could costlessly invest in currency rather than in activities bearing negative rates, then there
wouldn't be any negative rate activity in which people would invest. Consequently, the
negative interest rates in many European countries indicate that it is costly to invest in
currency to earn a zero nominal rate of interest.
Why is this the case? First, currency is bulky and weighty. For example, a million U.S.
dollars, made up solely of $100 bills, would form a stack measuring approximately 43 inches
or 109 centimeters in height and weighing 22 pounds or about 10 kilos. Consequently,
currency is inconvenient to use, especially for those who seek to make large investments or
payments. Second, currency is subject to theft, requiring a big investment in security and
insurance. Third, recounting currency every time it is moved or transferred between people
entails time and expense. Finally, currency is subject to degradation, accident, fire,
counterfeiting, and other mishaps.
Because currency is costly to invest in, then we could refine the proposition we stated earlier
to say that a person would invest a dollar in an account or bond that promises to pay back
less than a dollar so long as the person could not preserve more of his or her initial wealth by
investing in currency, net of its costs. So one might suggest that it is the negative net return
on currency that establishes the lower bound to interest rates - zero is only a rough
approximation. This formulation is sharper, certainly, but it may also be too blunt for the
following reason. Notice that the costs of handling currency vary by the size of the
investment one is considering. An ordinary person, with a few hundred or a few thousand
dollars to invest, may find it perfectly convenient to invest in currency, and to store most of it
in a safety-deposit box, one that the person may well have already rented to store important
papers or other valuables. A large corporation, in contrast, likely would find dealing in
currency extremely costly. So the proposition may be refined further to state that different
economic agents will be more or less willing to invest in negative rate investments to the
extent that diseconomies of scale make their costs of handling currency higher or lower than
others'.
Vaults introduce some additional considerations affecting the costs of holding currency.
Often, the costs of holding currency securely, by having a safety deposit box or a vault, are
fixed costs. Once one has a vault, or has rented a safety deposit box, the costs of storing
additional currency in it, up to its capacity, is nil. This suggests that there is a dynamic
element to the economics of avoiding negative interest rates: the longer the negative rates
are expected to persist, and the lower they are, the more favorable are the returns to
investing in a vault. Once the vault investment has been made, maintaining negative rates
would likely become more difficult.
An even more far-reaching change that many have suggested would be the creation of a
new institution to handle and store currency on behalf of others; this could dramatically
reduce the costs of holding currency. The institution contemplated would have a single,
highly trusted, party start a currency warehouse, which would consist of a large secure vault
and excellent record-keeping and shipping facilities. Individuals could then deposit currency
in the currency warehouse, receive receipts for their deposit, and then make payments with
the warehouse receipts. Such an innovation could conceivably lower the cost of holding
currency as an investment, and yield investors a return close to zero, but still slightly
negative.
Because of these dynamic considerations involving innovative actions to avoid negative
rates, we could add a corollary to our proposition. Specifically, we posit that different
economic agents will be less willing to invest in negative rate investments over time to the
extent that innovations reduce the costs of handling currency or make available other zero,
or near-zero, interest rate economic arrangements.
Some economists since Silvio Gesell - notably, Willem Buiter, Marvin Goodfriend, Miles
Kimball, and Ken Rogoff - have suggested that currency be eliminated, taxed, made
nonredeemable for deposits in banks, or made redeemable only in units that reflect an exchange
rate that varies over time.2 These are all other ways of imposing negative nominal rates
universally across the alternative means of payment people use. If such steps were
implemented and widely adopted, these proponents claim, there would no longer be a zero
bound on interest rates, primarily because currency would not offer a zero interest rate
alternative investment as a way to avoid negative rates on electronic bank balances.
These ideas are clever, but complicated and permanent in their effects. Without going
through the details of each proposal, let me discuss two of them: first, the proposal to
eliminate currency, and second, the proposal to have currency taxed or to have interest
collected from currency holders. By eliminating currency, the problem of avoiding the zero
lower bound would be greatly diminished. In his paper, Ken Rogoff suggests that the use of
currency, by allowing anonymity in trading, facilitates tax evasion and other criminal activity.
He points out many benefits of currency, including seignorage, lack of reliance on electronic
networks, transaction cost savings, and expanded civil liberties associated with additional
privacy. If these aren't enough however, let me suggest another, very important benefit of
currency that I explored in a paper with Charles Kahn and William Roberds.3
The anonymity afforded by currency transactions prevents a buyer from suffering from any
actions taken after the transactions that could exploit the knowledge gained by the seller of
the buyer's identity. For example, identity theft, or theft of credit or debit card information, is
avoided through the use of currency. This is an economic benefit that is distinct from valuing
privacy from a civil liberties point of view. If currency cannot be used in transactions, buyers
are at a disadvantage, and many otherwise beneficial transactions (not related to buyers
seeking to engage in tax evasion or otherwise illicit activity) would not take place.
It is important to consider whether the move to eliminate currency, or to alter radically how
currency works, represents a degradation or an improvement in technology. Should society
voluntarily abandon a widely used technology that has enormous benefits and features that
are currently irreplaceable, such as the privacy that comes with an untraceable transaction?
While some of those features are used by criminals to facilitate socially destructive activities,
the vast majority of currency uses are legal and productive. Until there are equally secure
electronic means of providing that anonymity, eliminating currency is not warranted.
Economists have proposed many clever ways to implement the taxation of currency, or,
equivalently, the payment of interest on currency holdings. Some of the proposals entail
decreasing the value of the currency by imposing a negative rate of interest. This can be
likened to making currency out of ice. As you can imagine, such cold currency would slowly
disappear as the ice turns into liquid water. (Other proposals would, in effect, attempt to raise
or lower the temperature of the air surrounding the ice money.)
One might conjecture that the loss of purchasing power is the same whether a person
holding a dollar for a period of a year sees the value of that dollar decline owing to inflation of
1 percent, or because he had to pay a penny of interest in an environment of stable prices.
However, there is a subtle difference between a negative rate of interest charged on
currency, and inflation decreasing the value of currency. With inflation, a dollar remains a
dollar, but its purchasing power declines. In contrast, with negative interest rates, the dollar
of currency is slowly whittled away as one makes interest payments, even though its
purchasing power can remain unchanged (this would be the case if prices fell by the same
rate as the negative interest rate). In other words, the value of the unit of account is
unchanged when a negative interest rate is charged on currency. In addition, dollars would
no longer be fungible, because each dollar would have a different amount of interest accrued
on it.
The difference in those two situations is the subject of money illusion - the behavioral
tendency of people to think in nominal terms.4 To the extent that money illusion is operative,
then imposing negative nominal interest rates will be perceived as more costly to people than
engineering an increase in inflation of the same amount - in both cases, the real wealth of
the person's money holdings is the same, but in the case of inflation, the person holds the
same number of dollars at the end of the period, whereas with negative nominal interest
rates, some of the person's money holdings have been paid out as interest. Money illusion
causes the payment of interest to be perceived as more costly, much as people resist
nominal decreases in wages which manifests itself as downward wage rigidity.
2. Legal and operational frictions
Legal and operational challenges will also arise as money and capital markets adjust to
negative rates. Many debt contracts feature floating interest rates; that is, the interest rate on
the debt is modified periodically to reflect prevailing market interest rates. But when the
contractual language does not contemplate the possibility of negative rates, complications
will ensue. In that event, the parties must renegotiate, which is difficult when the parties are
highly dispersed, and adjust the contractual language to address what happens when market
rates are negative. Another first-order operational problem is how to collect interest from
creditors: often debtors have few means of calculating interest payments due from creditors,
few easy ways to collect the payment, and a limited ability to enforce negative interest
payments from creditors. Given these realities, designing interest-bearing securities at
negative yields will require careful planning.
This topic alone is worthy of a longer treatment. In fact, my colleague Ken Garbade and I
wrote a piece on this topic, and I won't repeat the many considerations that enter into the
design of securities at negative rates.5 I will point out that because it is so challenging to
develop a practical way to collect periodic interest payments directly from holders, one
possible work-around is for the issuer of a fixed-rate bond to set the coupon rate to zero,
making the bond a single-payment security, and to sell the bond at a premium to its principal
value. Alternatively, an issuer could sell a bond with a negative coupon rate by providing that,
in the absence of timely payment of interest, the omitted interest payment will be deducted
from the principal due at maturity. In this case the bond would be redeemed for less than par,
depending on the number of unpaid coupons and the magnitude of the (negative) coupon
rate. These alternatives have different tax implications, as discussed in a recent report by the
Danish mortgage bankers.6
As one can imagine, these alternatives require a great deal of coordination and legal work to
implement. One legal issue is whether, in the case in which bonds are to be redeemed for
less than par, the bonds qualify to be used as collateral in various central bank or private
arrangements that require collateral; another is whether the decrease in the par value of the
bond might trigger a default that would require a writer of credit default swap protection to
make payment to the holder of the swap. These and similar operational problems (including
the difficulty of modifying security depositories and clearing and settlement systems to
manage the calculations and transfers associated with negative rates) can presumably be
solved in time. However, they represent expensive transition costs for those people and
institutions that must deal with them as rates move from positive to negative.
3. Economic frictions
There are many zero interest rate conventions in society: negative nominal rates, but not
negative real rates, reverse the incentives to exploit these conventions. The problem is that
the conventions evolved for a positive interest rate environment, and efforts to reverse the
direction of these incentives can lead to bad economic outcomes for society. Furthermore, it
is costly to change these conventions.
In many economic arrangements, including debt and tax payments, people can prepay debts
or tax obligations, or make excessive payments on them, and earn a zero return during the
prepayment period. For example, suppose that one holds a credit card under existing U.S.
rules: one can withdraw funds from an account that is earning a negative rate, and pay one's
debt to the credit card company in advance of when it is due, earning a zero return during the
prepayment period. Similarly, one can make excessive tax payments to the taxing authority,
and earn nothing during the period before one receives a refund, thereby avoiding negative
deposit rates at banks. Such "zero nominal rate" conventions abound in society, and the
lower the negative rate, the more people will search for such ways to avoid the negative
rates that might prevail elsewhere.7 Consequently, our proposition could now include this
consideration: Different economic agents will be more or less willing to invest in negative rate
investments to the extent that their costs of handling currency are lower or higher than
others', and to the extent they have available to them zero interest rate economic
arrangements. In addition, having talented individuals looking for these opportunities is a
dead-weight loss to society. We would rather have them use their talents for more socially
productive purposes.
In addition to the convention that all prepayments of debt carry a zero interest rate, creditors
often have the option of deciding when to settle a debt, for example by choosing when to
deposit a check once it is received. In an environment in which negative nominal rates
prevail, one would want to collect debts slowly (at least from creditworthy counterparties).8
For example, if one were to receive a check from the U.S. government for a tax refund, one
could simply put it in a safe place and earn zero interest on it during the time the check
remained undeposited. (These practices could trigger further innovations, such as a check
with a "deposit-by" date embedded in it.) How strong these incentives are depends on the
level of the negative rates. The lower the negative rate and the more persistent it is expected
to be, the more attractive these practices would be. Consequently, these zero rate economic
arrangements form another constraint that would prevent rates from going too far into
negative territory.
Notice that leaving the check undeposited, much like the hoarding of currency, is a negative
outcome for society. In this case, the receiver of the check is able to impose the costs of
earning negative deposit rates on the check writer. But this outcome turns on its head the
reason that the convention of allowing the check receiver the option of deciding when to
deposit a check was adopted in the first place. Under positive interest rates, the check
receiver has an incentive to deposit the check at his or her earliest convenience. In other
words, these conventions are incentive-compatible ways society has devised to enforce the
payment of debt, taxes, and other obligations. By reversing those incentives, negative rates
encourage the check receiver to deposit a check from a creditworthy source at his or her
latest convenience. This may impose unexpected costs on the check writer, triggering
unplanned overdrafts and associated charges, and, in this case, just as in the case of
currency, encouraging investment in undeposited checks, rather than in some productive
investment.
Once again, in these situations we should consider how innovations might alter the
possibilities to avoid negative rates over time. For example, faced with potentially large
repayments, many private contracts, such of those that allow prepayment or delayed deposit,
might be renegotiated, introducing additional legal and operational frictions.
4. Pass-through to market rates, and retail v. wholesale
Another practical challenge is that most if not all parties involved in negative interest rate
policies - central banks and commercial banks alike - may wish to immunize ordinary retail
bank depositors against experiencing negative interest rates. This is, in large part, a practical
concern. As I pointed out earlier, the costs of avoiding negative interest rates by substituting
currency for deposits is probably lower for retail depositors than for larger, business and
institutional, depositors. Because retail depositors can avoid negative rates on deposits
relatively easily, it makes sense not to impose negative rates on their deposits. In addition,
many retail depositors may have a visceral negative reaction to being charged negative
rates, and may lack a clear understanding of whether their bank is minimizing the costs of
storing their deposits.
Recognizing these difficulties, the central banks that have negative policy rates offer zero
rates on many of their deposits from banks, imposing negative rates on the "marginal"
deposits. In this way, commercial banks can, in general, charge their retail depositors deposit
rates of zero and earn zero at the central bank on at least a large portion of their reserve
holdings.
Observers report that retail depositors in Switzerland, Denmark, and Sweden do not face
negative deposit rates. At the same time, many large business and institutional depositors do
earn negative rates on their bank deposits. This state of affairs opens up new avenues, at
least in theory, by which some can avoid negative rates: large business depositors could
attempt to impersonate a host of retail depositors. While generally unrealistic, the possibility
of such a ploy requires that some effort be expended to prevent that avoidance activity. One
such effort might include frequent adjustments of the institutions or deposits subject to
negative rates (as we have seen recently in Denmark and Switzerland). The complications of
the negative rate policy only become greater once one realizes that it is a policy that is
intended to be passed through to most deposit and market interest rates, but not to retail
depositors.
5. Effects of negative rates on the health of financial intermediaries
A robust financial sector is important for many reasons: to direct savings into productive
uses; to assist households to smooth consumption; to facilitate trading, payment, clearing,
and settlement of financial assets; and to deliver insurance and pensions to people. The
health of banks and many other financial institutions depends on earning a spread between
what the institutions earn on their assets and what they pay on their liabilities. Negative rates
can squeeze bank profits. If banks are earning negative rates on their loans while charging a
zero rate to retail depositors, they lose money. If the goal of negative rates is to ease
financial conditions and provide stimulus to the economy, then the effects of the policy on the
health of financial intermediaries must be carefully assessed. Pension and insurance funds
too have potential difficulties in operating successfully in a negative interest rate
environment. They often provide liabilities - that is, promises of future pension payments or
insurance payments - at nominally fixed rates. If they can only invest in negative yield
instruments, their profits could be imperiled. Such possible profit squeezes could also prompt
financial institutions to take on inappropriately risky assets to earn an apparently positive
return. These concerns are present to some extent at very low rates, but they are magnified
at negative rates of interest, a point made by Ben Bernanke in his 2004 speech on the topic.9
A special case in the United States concerns the 2a-7 money market mutual funds, which are
more prevalent in the United States than in Europe. Money market mutual funds are
institutions that offer a floating rate of interest to shareholders that is intended to maintain the
value of a share in the fund equal to par, or very close to par, at all times. With negative
interest rates, and in the absence of a sponsor that is willing to subsidize shareholders in the
fund, such a financial institution would not be able to return a dollar invested today to a
shareholder the next day. In such circumstances, the fund must disband, as it has "broken
the buck." Recent SEC reforms specify that prime institutional funds be offered only shares
expressed as floating Net Asset Values in 2016, but retail and Treasury-only money funds
will retain a fixed NAV share structure, and therefore will still be subject to this complication
in an environment of negative nominal rates.10
6. Signal of deflation
Another complication centers on the signaling effects I mentioned earlier. When
implementing negative rates, central banks recognize that the signaling effects of their action
may be unpredictable. The inference drawn by people could be a negative one. For instance,
people could infer that the central bank itself has low expectations for inflation and is
lowering nominal rates into negative territory as a way to "ratify" the low expected inflation
environment. Such an inference would complicate the central bank's effort to achieve its
objective because it could encourage and entrench the public's expectations for deflation.11
That could complicate the potential exit from the negative rate regime.
7. Public acceptance
As with all public policies, negative nominal rates must be acceptable to the public if they are
to be a useful tool for central banks. Certainly, avoiding severely negative rates, especially
for retail depositors, would tend to reduce perceived adverse effects on households. There is
some anecdotal evidence that people in Switzerland, for example, on balance are not in
favor of negative rates.12 But businesses and households may feel that they have been
treated unfairly as they see others take advantage of various avoidance activities to which
they don't have access. Others may suffer the theft or loss of a currency hoard, possibly
resulting in feelings of regret after the fact, and place the blame on the negative rates. The
hoarding of cash itself is an unproductive investment that drains resources from the financial
sector of the economy, and consequently, may result in less efficient payments, difficulties in
obtaining loans, and other probl