The Potential Power of Negative Nominal Interest Rates

(Very Long - But You Can Skip the Postscript if You Want)

Last week, the Bank of Japan (BOJ) lowered its marginal bank deposit rate below zero.  Its action followed similar moves by many European central banks.  In this post, I’ll discuss how negative nominal interest rates can be a useful tool of monetary policy.  I’ll argue that central banks can only achieve the full power of this new tool if they treat it as completely standard, as opposed to a temporary emergency measure. 

Why might negative nominal interest rates be desirable to a central bank?  The general thinking in economics is that the incentives to spend, rather than save, are shaped by the real (that is, net of inflation) interest rate.  Negative nominal interest rates allow a central bank to achieve lower real interest rates, without raising inflation expectations.  

For example, suppose a central bank is unwilling or unable to raise medium-term inflation expectations much above 2%.   Suppose too that it faces a zero lower bound on the nominal interest rate.  Then, the central bank cannot lower the real interest rate much below -2%.   In contrast, if the central bank can lower the nominal interest rate to -1%, it can lower the real interest rate to -3%.  

In this sense, a negative nominal interest rate gives more policy space to the central bank.   It has much the same benefits as raising the inflation target, without the costs associated with higher inflation. 

There have to be limits on how negative nominal interest rates can go.   Households and businesses always have the option to switch to cash, which has an apparent nominal yield of zero.   But cash is relatively bulky and is not always easy to store or transport safely.  These costs mean that the true nominal yield to cash is less than zero.  The experience in Europe has suggested that cash’s costs allow central banks to lower nominal interest rates much further below zero than might have been thought. 

So, negative nominal interest rates give a central bank more policy space.  My second - and main point - is that this space will be of little use unless negative nominal interest rates are deployed in conjunction with the right central bank communication. 

Here’s the wrong way to communicate: keep saying that negative is a purely emergency setting that will be abandoned shortly.  The impact of policy depends on the expected path of interest rates over the medium and longer term.   The central bank’s communication means that its expanded policy space will have little influence on those medium and longer term expectations.   Note that even if the central bank actually keeps rates negative for many years, this ongoing communication will systematically rob the policy of its effectiveness (as well as hurting central bank credibility).

Here’s the right way to communicate: keep saying that all available tools, including negative interest rates, will be used as is needed to return employment and inflation to desirable levels as rapidly as possible.   This communication means that the public and markets know that the new policy space can be used to buffer the economy against any adverse shock.

To sum up: I see negative nominal interest rates as a potentially powerful tool for central banks.  But negative rates will only be an effective form of stimulus if they are treated as being fully conventional, as opposed to an unconventional emergency measure. 


Here are responses to some questions that I’ve been asked about negative nominal interest rates.

  • Can the Fed achieve a negative target for the fed funds rate, given its existing statutory authorities?  I’m not a lawyer.  But see Vice-Chair Fischer’s comments about negative nominal interest rates in his January 3, 2016 speech.   He does not mention any concerns on this dimension.
  • What are the financial stability costs of negative nominal interest rates?  It has been argued that low nominal and real interest rates may be a source of financial instability (like bubbles and undue risk-taking).  I’ve discussed this issue here.  But I don’t see anything special in this regard about slightly negative nominal interest rates (like -0.5% or -1%), as opposed to zero nominal interest rates.  (There may be other resource distortions related to negative nominal interest rates - see Rognlie (2015).) 
  • You predicted that the FOMC would use negative interest rates in 2016.  How do you feel about that prediction now? Actually, I’ve never made such a prediction.  I did say in October 2015 that it would be appropriate monetary policy to lower the fed funds rate target range below zero, in order to facilitate a more rapid return of inflation and employment to desirable levels.  (I still feel that the current macroeconomic situation requires a U-turn in monetary policy.)  I didn't anticipate that the FOMC would actually take such a policy step.  My overarching concern is that the FOMC will only use negative nominal interest rates in what it would characterize as an emergency situation.  As discussed above, this kind of approach would mean that negative nominal interest rates would not be of much use in the US.

N. Kocherlakota

Rochester, NY, February 1, 2016

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