Why S.F. Fed researcher backs negative rates

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A negative Federal Reserve monetary policy rate could have helped turn the economy around faster during the Great Recession, according to a Federal Reserve Bank of San Francisco researcher.

"While it's difficult to capture all the complexities of the economy in a model, this analysis suggests that negative rates could have mitigated the depth of the recession and sped up the recovery, though they would have had little effect on economic activity beyond 2014," Vasco Cúrdia, a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco says in an Economic Letter. "The analysis also shows that the interest rate does not have to fall too deeply into negative territory to accomplish meaningful economic improvements."

Inflation would have risen faster toward the Fed’s 2% target, he said. “In other words, negative interest rates may be a useful tool to promote the Fed's dual mandate.”

Historically, it was assumed nominal interest rates could not be lowered after they hit zero, and while the Federal Reserve used unconventional monetary policy tools, including forward guidance and quantitative easing when the fed funds rate hit zero lower bound, central banks in Switzerland, Sweden, Japan, and the euro area tried negative rates.

“A negative interest rate implies that savers pay rather than receive accumulated interest. This seems counterintuitive because savers can always take money out of that account and keep it in the form of cash,” Cúrdia writes. “Therefore, there is no reason to accept a negative rate, so zero ought to be the lowest level the interest rate could fall to.”

But, there are advantages to keeping money in banks, even if rates are negative, including: possibility theft or loss if one has a large amount of cash; the need for a bank accounts to access some other financial tools. “This means that people might reasonably decide to tolerate a negative rate on their savings in exchange for those benefits” he said.

Because there’s limited history with negative rates — they’ve been used infrequently and for short terms — it would be “difficult to establish a reliable statistical pattern regarding its effects.”

As a result, Cúrdia developed a model to “quantify the expected shifts in U.S. economic conditions after the financial crisis,” which showed using negative nates “would have pushed up both the output gap and inflation through the recovery. Namely, instead of a trough of –3.8%, the output gap would have been no lower than –3% and it would have been on a steadier path to recovery from 2010 onward.”

Using negative rates, the simulations suggest, “would have reached its maximum effect in the first quarter of 2011. Setting the lower bound at –0.25% would have increased the output gap by 1.5 percentage points, while pushing the lower bound down further to –0.75% would have contributed an additional 0.4 percentage point to the output gap. This means that a rate of –0.25% would have done most of the job, and allowing it to drop further would have accomplished fewer additional benefits.”

Negative interest rates would have little impact from 2014, he said, since “the stimulus would have pushed inflation higher as well, perhaps even modestly above the 2% Federal Open Market Committee target, by the middle of 2011.”

Cúrdia notes that his model cannot be “guaranteed to accurately mimic outcomes in the complex U.S. economy,” and should be see “as an estimate to illustrate how much stimulus negative rates can provide, although the exact numbers are not definitive.” The model also assumes the impact on the economy from “rate changes are largely unchanged in the event of a negative rate,” but in reality, a negative rate could reduce savings. “In this case, a negative interest rate would be less stimulative than my analysis suggests.”

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Monetary policy Negative rates Federal Reserve Federal Reserve Bank of San Francisco FOMC
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