The Fed’s recession bind, in one chart

October 15, 2012

You can't go below zero. But man, it'd sure be nice if you could. That's the conclusion of a new report from two economists at the Cleveland Fed, who say that the downturn in 2009 called for Fed interest rates to actually be negative — if only that were possible.

This is the main dilemma for central banks during deep recessions like the one from which we're currently emerging. In normal times, if a slump is coming, the Fed and its counterparts in other countries will slash interest rates. If the rate was 5 percent and the Fed slashed it to 2, that reduces banks' incentive to hoard money and encourages lending, which in turn boosts the economy.

But what happens when interest rates are already extremely low, and that's not enough to take the economy out of its slump? The Fed's rate is currently set at a range of 0 percent to 0.25 percent. You can't go much lower than that without things getting real weird. Negative interest rates basically mean that the bank is charging you money to stash your savings with them. In that situation, many people would just hold cash, which at least has a 0 percent return.

There are some situations where this isn't practical. Large companies aren't going to go all "Breaking Bad" and just keep big piles of $100 bills around. Indeed, Sweden has tried a negative 0.25 percent interest rate on bank reserves, with encouraging results, suggesting the impediments to holding cash are big enough for negative rates to work.

But there are workarounds. Kenneth Garbade and Jamie McAndrews at the New York Fed warned earlier this year that negative interest rates would lead to "special purpose banking," in which companies offer effectively sky-high returns by promising to just keep peoples' money in the form of cash. Garbade and McAndrews also envision people delaying depositing checks, knowing that if they put it in their bank account immediately, it'll start losing value. To avoid these problems altogether, you'd need to take a drastic step like abolishing paper currency. While some, like Citigroup's Willem Buiter, have proposed just that, it doesn't seem in the offing for any countries anytime soon.

Which is too bad, since the data suggest that we really needed negative interest rates in 2009. I did some back of the envelope math a while back showing that under popular policy rules for determining interest rates, rates should have reached close to -4 percent in 2009. Now, two economists at the Cleveland Fed, Ellis Tallman and Saeed Zaman, argue that, if anything, that's too timid. They believe rates should have reached -5 percent:


 Tallman and Zaman

The red line is the actual policy the Fed has taken, and the blue line is the policy which Tallman and Zaman estimate would have been taken if the Fed followed past patterns for changing rates. The rate, if the Fed followed past policies, would have dipped to -5 percent in mid-2009, and still be around -2 percent today. What's more, the results are statistically significant at a 90 percent level, as you can see from the fact that even the upper 90 percent confidence bound is negative until the start of 2011.

The Fed has tried to get around this through quantitative easing, and fiscal stimulus as implemented by the American Recovery and Reinvestment Act is another way of getting around the "zero lower bound." Some, like Columbia's Michael Woodford, have suggested getting around it by making promises about how long interest rates will stay at zero, an approach which the Fed has also adopted in a limited form and appears set to embrace wholesale.

But as Tallman and Zaman show, one wouldn't even need to get that creative if the Fed were able to go negative. And given that the Fed acts faster to change interest rates than to do more exotic things like QE, and that Congress acts much more slowly than the Fed ever does, that could have sped up the recovery.

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