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May 27, 2009
Negative nominal interest rates in the US?
Professor Gregory N Mankiw wrote a very interesting article entitled "It may be time for the Fed to go negative", The New York Times,18-Apr-09. Professor Mankiw gives the following example (borrowed from a student attending one of his seminars) :
"Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.
Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit."
"Fed Study puts ideal interest rate at -5%", Financial Times, 27-Apr-09 is interesting.
And read this: "FRBSF Economic Letter 2009-17; May 22, 2009: The Fed's Monetary Policy Response to the Current Crisis"
I would like to point out a few problem areas with reference to negative nominal interest rates in the US.
1.The US receives net foreign capital flows into its debt market. At least for the risk-free US$ denominated bonds, there may not be any takers among the non-US investors in a negative interest rate scenario . They (Central Banks of China, Japan, Russia and India; as well the oil-rich nations in West Asia) might sharply accelerate their movement away from the dollar. Which country would be willing to lend the US a hundred dollars and get only ninety-nine dollars in return?Further, the change to the euro (or SDR?) as the world's reserve currency could lead to the commodities' prices being denominated in euro (or SDR).Do you think its worth risking the dollar's status as the world's reserve currency? Or
would it be more meaningful to engineer a one-time sharp devaluation in the dollar...it could easily be done by the US Treasury announcing an issuance of euro, yuan, yen, rouble and rupee denominated debt. The sharp devaluation would give lower return on existing holdings, and new foreign currency issuances would give the non-US investors another route for investing in the US' debt market and perhaps not precipitate a change the choice of the global reserve currency.
2. A "negative interest rate solution" cannot exist as a temporary one-off measure. Since the idea is to stimulate consumption, I presume that whenever the negative interest rate solution (say with a negative Fed Funds target rate accompanied by debasement of some currency notes...) is implemented, no part of the yield curve will be positive. As otherwise, there could be a postponement of demand rather than its preponement.It might be possible to make risk-free profit in a scenario where the entire yield curve is below zero, by effectively locking into a negative borrowing cost for a future date (if a negative interest rate regime does not recur). And since risk-free profit is impossible in equilibrim, I say that the recurrence of a negative-interest rate regime has a non-zero probability i.e. a negative interest rate regime may recurr.
3. CONFIDENCE : This could really be problem#1 since a legilative solution which enables the Fed not to honour its commitment of US$ 100 with US$ 100 (instead with a lower amount) will very likely cause a loss of confidence. I think the loss of confidence is even more likely once the general populace feels that its not a short-term temporary measure.
An inference : Interest rate option models will have to be revised!(This is not a real problem area)
Posted by amgodbole at May 27, 2009 01:27 PM
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