What If Interest Rates Go Negative?

During his speech last week's Jackson Hole, Wyoming, meeting, Federal Reserve chairman Ben Bernanke gave broad hints that the Fed was considering additional steps in trying to spur economic growth:

JACKSON HOLE, Wyo. — The Federal Reserve chairman, Ben S. Bernanke, signaled once again on Friday that the central bank was prepared to act if the economy continued to weaken, as yet another economic report confirmed that the recovery had slowed to a crawl...
 
While Mr. Bernanke announced no new steps that the Fed would take immediately, he said the central bank was determined to prevent the economy from slipping into a cycle of falling wages and prices, a situation he said he did not think was likely. Instead he predicted that growth would continue modestly in the second half of the year and pick up in 2011. 

http://www.nytimes.com/2010/08/28/business/economy/28fed.html?pagewanted=all

The Times article went on to describe a variety of different monetary tools the Fed might consider, but with interest rates a historic lows many observers are questioning how much firepower the Fed actually has left.

But other economists are looking at more innovative ideas to try to spur economic growth.

One of the more intriguing ideas was the subject of a paper written by two economists from the New York Federal Reserve.

Co-authored by Kenneth Garbade and Jamie McAndrews, the article discussing the idea to charge banks a fee for excess reserves, i.e. negative interest rates.  The hope would be to try to force more lending and investing, and reduce the huge stockpiles of cash reserves, by making hoarding cash an expensive proposition:

 One way to push short-term rates negative would be to charge interest on excess bank reserves. The interest rate paid by the Fed on excess reserves, the so-called IOER, is a benchmark for a wide variety of short-term rates, including rates on Treasury bills, commercial paper, and interbank loans. If the Fed pushes the IOER below zero, other rates are likely to follow.

http://libertystreeteconomics.newyorkfed.org/2012/08/if-interest-rates-go-negative-or-be-careful-what-you-wish-for.html

If you follow the link, you will find the article, which generally comes out against a negative interest rate policy, because of the number of likely unwanted consequences a negative interest rate policy would carry.

But the idea still should be considered by investors, particularly if you believe that Governor Romney will be our next President.

Romney has strongly suggested that if he becomes President he will move to replace Ben Bernanke when Bernanke's term expires in 2013.  One of the leading candidates to replace the current Fed Chair would be Harvard professor Gregory Mankiw, who played a prominent role in advising President George W. Bush.

In 2009 Professor Mankiw wrote an editorial for the New York Times that suggested that the Fed discussed the concept of a negative interest rate policy.  While he agrees that the idea has a number of problems, he also suggested that there might be ways that moving interest rates to below zero might work.

Here's an excerpt:
 
The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them. 

In many ways today, the Fed is in uncharted waters.

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1