Sunday, November 20, 2011

Negative Interest Rates

Why is there a zero nominal bound on interest rates?

According to Todd Keister, from the New York Fed:

Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive.

In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.

In other words, the reason there is a zero nominal bound is that the Federal Reserve chooses to keep interest rates above zero.

Keister had already pointed out how interest rates have been below zero for limited periods of time. He also explains why. It is costly to store currency, especially large quantities. As I have explained in the past, this makes the lower bound on nominal interest rates equal to the cost of storing currency.

Of course, the Federal Reserve is very committed to framing its actions in terms of setting interest rates. From that perspective, the Fed chooses to keep interest rates above zero.

If, for example, the Fed was targeting the quantity of base money, and there were a shortage of T-bills at a nominal interest rate of zero--perhaps because of a flight to safety--then the interest rate would fall until storing currency is cheaper. In other words, paying for safes, guards, and the like.

However, to avoid "money market disruptions," the Fed would seek to prevent this. The most obvious course would be to change its target for base money, reducing the quantity of base money. The resulting excess demand for base money should create a liquidity effect that would at least temporarily raise short term money market yields.

What would be the disruptions that would justify engineering an imbalance between the quantity of money and the demand to hold it? As is usual, there is an air of "only the central bankers know."

Still, Keister provides three possible problems.
Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.
Since ordinary mutual funds have no difficulty in charging for their services when the underlying portfolio suffers looses, this is a bit of a puzzle. The marketing material for money market funds claims they work very hard to prevent capital loss, and in the Fall of 2008, the "breaking the buck" by Primary Reserve fund, suggests it is possible. Do mutual funds charge for their services as a percent of yield rather than total assets managed like stock mutual funds. Regardless, perhaps it is time for mutual funds to change their rules.

Keister continues:
The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.

The New York Fed (along with the Office of the Public Debt,) operates the T-bill auctions. The Fed generates monetary disequilibrium to avoid the inconvenience of modifying their procedures in operating the auctions to clear markets? How hard could it be to allow bids of negative yields?

And finally:
A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.

So, if market interest rates become negative, then banks would not be motivated to borrow overnight. It is difficult to see why that is true. Certainly, the problem would be the opposite. If the interest rate on reserves is zero, and the federal funds rate is negative, then holding reserves is better than lending them. If the interest rates paid on reserves were negative, along with other short term interest rates, then lending reserves at less negative rate would be desirable. Of course, if the interest rate on overnight loans (or the interest rate on reserves) approaches the cost of holding vault cash, then there would be no motivation to lend.

Frankly, these reasons for keeping interest rates above market clearing levels look to be excuses....bad excuses. Unfortunately, as long as the Fed frames its activity as setting interest rates rather than avoiding imbalances between the quantity of money and the demand to hold it, creating monetary imbalances to manipulate interest rates will seem natural.


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