Negative interest rates?

[I've been out of town and feeling lazy lately, hence the pause in blogging. Time to get back in the swing.]

A number of commentators are suggesting that the Fed reduce the interest it pays on reserves below zero. That is, whereas currently the Fed pays banks an interest rate of 0.25 percent on excess reserves (and banks now hold about a trillion dollars in excess reserves), the Fed could in principal reduce that to zero or negative whatever it wanted. Penalized for holding money idle, banks would have a strong incentive to make loans. There are two problems however:

1. It's not clear whether the Fed has the legal authority to do this. The law says the Fed can pay interest on reserves, but it does not explicitly say the Fed can charge interest. The Fed might be able to get around a prohibition on negative interest by charging banks "fees" that act like interest, but this would have to be cleared through legal, as they say.

2. If the Fed charged an appreciable amount of interest banks would choose to store their reserves as "vault cash" rather than their deposits at the Fed. The Fed might be able to counteract this move by including vault cash in the measure of reserves to be charged interest, but again it's not clear if this is legal. (I'm told that the Fed's mandate to provide an "elastic currency" would get in the way of this action.)

Discussing these options with a friend at the Fed I mentioned that the Fed needs to hire some more bankers. Bankers are very good at finding ways to screw their customers with hidden fees, which is just what the Fed needs to do to banks right now. "That's funny," he said, but I thought I detected a hint of melancholy in his voice as he said it.

This recession is different, but not in the way you think

First we have the article mentioned below in which David Leonhardt argues that we might be a bit too pessimistic about the possibility of recovery - after all, everyone was pessimistic in 1982, and soon thereafter the economy went on a tear.

Calculated Risk responds that things are different this time (ignoring Leonhardt's point that things are always different this time):

Second, most recessions have followed interest rate increases from the Fed to fight inflation, and after the recession starts, the Fed lowers interest rates. There is research suggesting the Fed would have to push the Fed funds rate negative to achieve the same monetary stimulus as following previous recessions (see San Francisco Fed Letter by Glenn Rudebusch The Fed's Monetary Policy Response to the Current Crisis). Welcome to ZIRP! (Note: Professor Taylor disagrees on the size of the negative Fed funds rate).

Paul Krugman's response to Leonhardt echoes that of Calculated Risk:

OK, although I’m with Calculated Risk: we’re really in a liquidity trap now, which means that it’s much harder for the Fed to turn things around.

What CR and Krugman are talking about is the graph below. The graph shows the federal funds rate from six months before the trough of the last five recessions to 12 months after, normalized to zero in the month of the trough. (I'm assuming the 2007-09 recession ended in July and show the fed funds rate for the following three months.)

The blue and red lines are the recoveries following the two big recessions of 1974-75 and 1981-82. In each case, beginning 6 months before the trough the Fed drastically cut the federal funds rate (by 6 percentage points, give or take), then let rates drift down some more after the trough. The drop in rates was smaller but still noticeable - 2 percentage points - in the 1990-91 and 2001 recessions; in the 2001 recession the fed funds rate continued to fall for a year into the recovery. But in this recession, the Fed used up all its ammunition in the first year of the recession. By last spring the fed funds rate was already zero, so it did not fall at all during the six months leading up to the recovery, and is not going to fall in the months to come. Leonhardt and Krugman conclude that we're in worse shape now: because we're hard up against the zero bound, monetary policy won't bail us out of this one.

But wait. The interest rates that are most important as determinants of aggregate demand are things like corporate bond rates and mortgage rates (and we're interested in the real rates, not nominal). The federal funds rate is important only to the extent that changes in the fed funds rate affect these other interest rates. The Fed has been trying to change real long-term risky interest rates through unconventional means: providing liquidity to the banking system, intervening in credit markets, and buying long-term Treasury bonds, agency debt, and mortgage-backed securities. A more meaningful measure of the stance of monetary policy today and in recoveries past is how real long-term risky interest rates behaved. So let's look at the real yield on Baa corporate bonds:

What we see is that the amount of monetary stimulus we've been getting in the last nine months stacks up pretty well against the record of previous recessions. In the six months leading up to the recovery that began in 1982 the real Baa rate fell by about 2 percentage points; for the recovery that began in 1975 it fell about half a percentage point; and for this recovery it fell by about 1 percentage point. The real Baa rate has continued to fall since July, by more than it did in the months following the 1982 recovery. After the recovery that began in 1975 the real Baa rate shot up rather than falling. So by this measure we've got more stimulus than in 1975 and almost as much as in 1982; and a lot more than in 1991 and 2001.

On the other hand, it may be the level of the real Baa rate, not the change, that is important. When the recovery began in 1975 the real Baa rate was an incredibly low 0.48 percent versus 5.69 percent today - with interest rates that low it's a wonder everyone didn't start borrowing (and I think everyone did!). But the real Baa rate is not as high now as it was at the start of the 1982 recovery. It's also lower than it was in 1991 and 2001. Again - there's more monetary stimulus in our economy today than there was in four of the last five recessions.

There may be many things that are different about this recovery than previous strong recoveries, but lack of monetary stimulus is not one of them.