Negative Rates: A Gigantic Fiscal Policy Failure


Since October 2015, I’ve argued that the Federal Open Market Committee (FOMC) should reduce the target range for the fed funds rate below zero.   Such a move would be appropriate for three reasons:


  1. It would facilitate a more rapid return of inflation to target.
  2. It would help reduce labor market slack more rapidly.
  3. It would slow and hopefully reverse the ongoing and dangerous slide in inflation expectations. 


So, going negative is daring but appropriate monetary policy.   But it is a sign of a terrible policy failure by fiscal policymakers.


The reason that the FOMC has to go negative is because the natural real rate of interest r* (defined to be the real interest rate consistent with the FOMC’s mandated inflation and employment goals) is so low.   The low natural real interest rate is a signal that households and businesses around the world desperately want to buy and hold debt issued by the US government.   (Yes, there is already a lot of that debt out there - but its high price is a clear signal that still more should be issued.)  The US government should be issuing that debt that the public wants so desperately and using the proceeds to undertake investments of social value.


But maybe there are no such investments?  That’s a tough argument to sustain quantitatively.  The current market real interest rate - which I would argue is actually above the natural real rate r* - is about 1% out to thirty years.  This low natural real rate represents an incredible opportunity for the US. We can afford to do more to ensure that all of our cities have safe water for our children to drink.  We can afford to do more to ensure that our nuclear power plants won’t spring leaks.  We can afford to do more to ensure that our bridges won’t collapse under commuters.


These opportunities barely scratch the surface.  With a 30-year r* below 1%, our government can afford to make progress on a myriad of social problems.  It is choosing not to. 


If the government issued more debt and undertook these opportunities, it would push up r*.  That would make life easier for monetary policymakers, because they could achieve their mandated objectives with higher nominal interest rates. But, more importantly, the change in fiscal policy would make life a lot better for all of us. 


I don't think that Chair Yellen will say the above in her Humphrey-Hawkins testimony tomorrow - but I also think that it would be great if she did.  


N. Kocherlakota

Rochester, NY, February 9, 2016


Please address media enquiries and non-academic speaking requests to Monique Patenaude (monique.patenaude@rochester.edu and 585-276-3693).


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