Sunday, August 7, 2011

Negative Nominal Interest Rates and... The Real World!

Yields on short and safe assets went negative last week.

Here is an article from Bloomberg.

Was this because there is an excess supply of money?   Did firms and households have excess money balances, spend them to purchase financial assets, push up their prices, and so lower their yields?

If that were true, then this would be an early sign of monetary disequilibrium leading to inflation.

But NO!

What happened is that people sold off stocks and purchased short term government bonds and parked money in FDIC insured deposit accounts.   There was a shift from more risky assets to safer assets.  Money--whether currency, FDIC insured deposits, or money market funds invested in T-bills are short and safe assets as well.  It was the market clearing rates on those short and safe assets that turned negative.

To the degree that banks start accumulating vault cash or people buy safes and hoard currency, the problem will be an excess demand for money, not an excess supply.   If people demand more FDIC insured deposits or money market funds invested in T-bills, then this is an excess demand for money.

If the Fed responds to these negative interest rates by open market sales or raising the interest rate it pays on bank reserve accounts, it would be seeking to create an excess demand for money--generating monetary disequilibrium.   To the degree the liquidity crunch has the usual short run effect of raising short term interest rates, the Fed would be exacerbating the underlying problem.

If the Fed responds by raising the interest rate it pays on reserves and purchasing more risky assets (say stocks or Greek bonds,) then it would be carrying additional risk for banks directly, and their depositors indirectly.    This would "solve" the problem of avoiding monetary disequilibrium while providing risk adverse investors good yields, but is it desirable?

I think the answer is no.

In my view, negative interest rates on short and safe assets is the least bad outcome in this case.   It dampens the sell off of the risky assets, or more likely, channels the funds to other, slightly less risky areas.   Higher risk stocks and bonds are sold to purchase lower risk stocks and bonds.

Anyway, privatize hand-to-hand currency and _don't_ make hand-to-hand currency FDIC insured.   Let the banks make it junior to deposits.   And then let interest rates on short and safe assets go as negative as needed to clear markets.

Of course, given a targeted growth path for GDP (money expenditures on domestically-produced output.)

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