Negative Rates Advocate Spells Out the Obstacles at Jackson Hole

  • Ex-Fed economist Goodfriend: May need to abolish paper money
  • ‘Nothing more than the sensible application’ of economics

What should policy makers do if the next recession hits before central bankers climb out of their low-interest-rate fox holes?

Carnegie Mellon University professor Marvin Goodfriend gamely took up that question in a paper he delivered Friday at the Federal Reserve Bank of Kansas City’s annual retreat in Jackson Hole, Wyoming, making a case for why aggressive negative interest rates might be the best answer. However, by meticulously detailing the groundwork necessary to make negative interest rates effective, Goodfriend arguably also showed why they may never happen in the U.S.

The paper comes as officials debate the usefulness of negative rates deployed by the European Central Bank, Bank of Japan and several other European countries. Mark Carney, governor of the Bank of England, earlier this month rejected the idea of negative rates as an effective option and Fed Chair Janet Yellen has also played down the strategy as a productive approach to tackling the next downturn in the U.S.

Goodfriend, a former director of research at the Richmond Fed, is no fan of quantitative easing, the strategy of buying bonds when a central bank’s benchmark interest rate reaches zero. Its effectiveness in the longer-term is questionable, he said, and it steps into the domain of fiscal policy.

Negative rates, by contrast, stay firmly in the realm of monetary policy and don’t risk distorting credit markets. Making them easier to implement in the U.S. would afford the Fed more flexibility, akin to dropping the Gold Standard or a fixed exchange-rate system, he wrote.

Aggressive Action

So, negative rates it is, and we’re likely to need them, Goodfriend argued.

“Low long-term nominal interest rates today reflect underlying forces unlikely to dissipate any time soon,” he wrote. “It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions.”

Based on how the Fed reacted to recessions over the past 50 years, should a severe recession hit now, he says policy makers would want to push rates as low as minus 2 percent.

But there’s a problem. Goodfriend points to “long-standing institutional arrangements” under which the Fed doesn’t charge for cash deposits. Retail banks are also shy about charging customers to hold their cash, in the fear they will prompt widespread mattress stuffing.

Deep Negative

In that environment, if the Fed goes deeply into negative territory for what is likely to be an extended period, it will drive bond holders out of negative-bearing securities and into zero-interest cash, leading to what Goodfriend calls “a destructive dis-intermediation of financial markets.”

To prevent that, Goodfriend offers three ambitious options: Abolish paper currency; introduce a market-determined price for cash deposits that would rise whenever the policy rate went negative; or offer electronic currency as a substitute for paper currency on which the Fed can set a positive or negative interest rate.

Goodfriend concedes the public would probably reject option one, and option three would require “considerable investment in banking, central banking and payment system infrastructure before it could be made available.”

Option two, while it could be achieved “expeditiously,” according to Goodfriend, would also involve introducing a complex rule for determining a flexible deposit price for paper currency. As challenging as some of these obstacles might be to surmount, Goodfriend argued “removing the zero lower bound is nothing more than the sensible application of monetary economics.”