Negative interest rate apologetics

24 August 2016

Former Bank of England MPC member (now president of the Petersen Institute of Economic Affairs) Adam Posen has got an FT column in which he writes about negative interest rates.  He focuses on what he thinks are two analytical errors routinely made in the discussion about negative interest rates, which, in his view, have mostly had the expected effect and are, after all, not that big a deal. The impression one gets, though never explicitly stated, is that he thinks that negative interest rates are quite simply not enough.
The first fallacy Posen discusses is the belief that most major financial decisions respond strongly to just about any changes in (mostly) short-term government borrowing costs. Posen notes that while this was indeed the case during America’s great moderation, this was an atypical episode. Consequently, monetary policy would normally require a host of different instruments to be effective. In other words, according to Posen unconventional monetary policy phobia is not warranted. Unconventional monetary policy, in his mind, is not really that nonconventional, it merely makes use of a range of different tools to allow policy makers to hit their targets.
He notes that significant structural differences across countries go a long way to blunt or amplify the effectiveness of cutting interest rates to sub-zero levels. As he points out, in some Eurozone economies most consumers stash their savings in bank deposits and most businesses finance themselves through bank loans. In Anglophone countries, however, corporates and consumers alike usually rely on a wider array of savings and financing. That, he notes, should be kept in mind to gauge the extent to which negative rates would be effective, with more muted reactions in the Eurozone, for instance, relative to the US, Australia, or Canada.
In his view, a second major fallacy is the commentariat’s (and armchair economist’s) tendency to overlook the political context and engage in broad generalisations. He argues that officials and regulators would be prone to be much more resistant to negative interest rates in countries with more traditional banking systems. In contrast, where there are more options there will be less resistance. He points out that capital mobility in fact does vary significantly across countries, regardless of whether the capital account is formally open or otherwise. The argument is that Japanese savers, for instance, are much less likely to move assets abroad than their Swiss counterparts, with obvious implications for the amount of resistance that such policies would conjure up.
It’s easy to be sympathetic to his observation that the impact of negative interest rates depends on the structure of the economy to which they apply. There is little doubt that it does. It is altogether harder to agree with the notion that before the great moderation shifts in the government cost of borrowing were but one of several tools used by central banks to smooth out fluctuations in output and inflation. Posen does not address the biggest problem with negative rates which is their destabilising effect on pension and life insurance funds. Negative rates render current rate of return assumptions null and void. If pensioners realise this, they will save even more to offset lower predicted payouts from their long-term funds.
Adam Posen is a former policy maker. What about current ones? This brings us to the latest rumblings coming from deep inside the Federal Reserve’s system -specifically, from Fed President John Williams. Williams has come out in favour of the view that the neutral (some call it natural, or real) rate of interest is very low and most likely to remain low. He explicitly calls for some serious consideration to be given to raising inflation targets and/or targeting nominal GDP.  Readers who experienced inflation in the 1970s might find the notion of higher inflation targets somewhat unnerving. However, advanced economies were vastly different then, and there is actually absolutely nothing sacrosanct about a 2% inflation target, while the advantages associated with raising target inflation to -say- 4% have been made abundantly obvious by the past decade of economic data. The problem, however, is that it’s unclear that doing so would be easy, considering that even hitting 2% hasn’t exactly been plain sailing.
Contrast what Posen and Williams have to say with the standard editorial on the WSJ, or with columns by famous (former) bond kings. Plenty of investors detest current monetary policy -of course, they had it so good for so long they just know something has to be wrong with monetary policy when returns aren’t what they used to be. It may be too early to tell whether it is policy making that has been erratic/too radical, or whether the problems that beset the real economy are quite simply beyond the reach of the current vintage of policy tools. Some prominent current and former policy makers seem to think it’s the latter. It will be interesting to see who’s proven right.


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