Negative interest rates? - Vested - Milton Ezrati, Chief Economist

Negative Interest Rates?

MILTON EZRATICHIEF ECONOMIST

President Donald Trump is pressing the Federal Reserve (Fed) hard to drive interest rates into negative territory.  He insists that a move in this direction will help induce recovery from the COVID-19 lockdowns and quarantines.  He points out further how other countries have fostered negative interest rates to help their economies, Japan and Germany among them.  The United States, the president has said, deserves the “gift” of negative rates.  Though the Fed readily brought short-term rates down to just about zero, it has so far resisted moving them still lower.  To counter Trump’s pressure, Fed Chairman Jay Powell has pointed out that other monetary actions already in place will do a better job fostering a strong economic recovery and that the experience with negative rates abroad hardly recommends them as an effective policy tool.  In this dispute, the weight of economic good sense would seem to lie with the Fed.

This is not the first time President Trump has pushed for negative interest rates.  He has in fact revisited this theme several times during his term in office. Just a year ago, the White House and the Fed had this kind of dispute.  When the Fed finally did lower rates last July, the president’s past insistence on rate cuts had been so intense that many in the media and Congress accused Chairman Powell of knuckling under to Trump.  It was an unfair accusation.  Powell had for months resisted presidential pressure and only moved when the ongoing trade war with China had clearly changed economic circumstances. 

Trump’s motivations for making his demands are clear enough.  He, like all presidents before him at this time in their administrations, has taken a singular focus on his re-election campaign.  (George Washington may be an exception to this rule, but if so, he is the only one.)  By the White House’s lights, matters demand prompt and dramatic economic stimulus on every front and regardless of other considerations, especially since Donald Trump will have to carry the lingering economic effects of the pandemic into his campaign.  

The Fed, however, is not running for office.  It can take a broader, longer-term approach to policy.  Indeed, its charter insists that it take a non-political, longer-term view.  So while the Fed is aware of the need for stimulus to bring the economy back after re-opening, it must also consider the effects of negative rates beyond their immediate stimulative effects.  It can see from foreign experience that negative interest rates more times than not have failed to generate much economic response.  There is also reason to worry that they distort financial decision-making because their unusual nature can confuse the rules of thumb and formal algorithms often used by traders and investors.  The Fed’s governors also worry that the introduction of negative rates now will strain bank finances, especially since the anti-virus quarantines and lockdowns have raised the risks of defaults and bankruptcies.  It is not that the Fed wants to protect bank profits but rather that it wants to avoid the kinds of financial fears and disruptions that plagued the economy in 2008-09.  

Although neither Powell nor other Fed governors have mentioned it, there is another, more fundamental reason why they might resist negative interest rates.  Even as a temporary measure, a drop in rates below zero might perversely injure the business confidence needed to promote recovery.  Because the returns offered in financial markets naturally reflect returns available in the larger economy, policy that pursues negative rates effectively announces that economic prospects are also low or negative.  The relationship stands to reason.  When returns to economic endeavor are high, business people will happily borrow so as to pursue those returns and accordingly push lending rates upward.  When those returns to economic endeavor are low, business has no appetite for expansion or borrowing, almost regardless of how low interest rates are.  Lending rates accordingly fall.  Low and especially negative returns, hint at this sad economic circumstance.  When countries such as Japan and Germany pursue negative interest rates, they use a desperate monetary gesture to address what is doubtless a deeper economic malaise, perhaps the need for regulatory reform or a new approach to trade or a change in labor law, things that might raise returns to economic endeavor.  To be sure, very low interest rates say something similar, but negative rates are a thing apart.

In response to all these considerations, Chairman Powell has countered the president’s pressure by pointing to the lower risks and greater efficacy of monetary policies already in place.  The Fed has, after all, brought short-term interest rates down near zero so that it is effectively costless or very inexpensive for businesses to borrow.  Under the broad heading of “quantitative easing,” the Fed has also entered financial markets through a number of programs to provide copious amounts of liquidity for individual and business borrowers, as well as municipalities and states.  All these measures should help protect the stability of financial markets and promote a robust recovery as anti-virus strictures lift.  They will do so, Powell implies, without the risks introduced by negative interest rates.

Whatever the economic fundamentals or the experience abroad, the dispute between the president and the Fed will play out in the political and not the economic arena.  If the economy responds smartly to the re-opening just now beginning, a gratified Donald Trump will look at the coming election with greater optimism.  Needing less help from monetary policy he will likely ease the pressure on the Fed, and the dispute will evanesce.  If, however, the economy fails to respond adequately to the re-opening and unemployment rates remain high, Donald Trump’s increasing desperation will redouble the pressure on the Fed, making negative interest rates a much greater likelihood, regardless of reasonable reservations of Chairman Jay Powell and other Fed governors.    

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