Who's Afraid of Negative Interest Rates?

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Economics still has its eternal verities, but more and more countries are now learning that a zero lower limit for interest rates is not one of them. I suggest this is not necessarily as unnatural as everyone thought - indeed, the possibility of negative interest could be a liberating discovery. But not for the reason that it adds capacity to the Fed's depleted tool box. When super-easy monetary policy has been a failure, I think the pursuit of hyper-easy monetary policy would defy logic.

The supposed impossibility of negative rates has been a lynchpin in much economic doctrine. It was important to Keynes' argument that a free-market economy may be unable to reach full-employment equilibrium without government intervention. It also created doubts that "easy" monetary policy would be sufficient, so helping create an intellectual case for large-scale government spending. Such doctrines are extremely powerful. Despite the ineffectiveness of either extreme monetary policy or bloated government, they are now more deeply embedded in the public mind than ever.

It is probably going to take a long time for people to get their heads around the idea of negative interest rates. The unfamiliar, at first, is often met with discomfort and disbelief.

It's common to see negative rates as an aberration that will soon disappear. The idea that $1,000 to be received a year from now could be worth more than $1,000 in the bag today is counter to common intuition. But actually, on further thought, it could. A present dollar is not the same as a future dollar. When inflation is sufficiently high, a future dollar is almost worthless. By the same logic, when prices are consistently falling, a future dollar could be more valuable than a present dollar. At a sufficiently high rate of deflation, interest rates ought to be negative.

This insight explains why episodes of negative interest rates are so rare, and why their potential existence was unrecognized for so long. Ignoring central-bank interference for a moment, the higher the sustained rate of inflation, the higher the interest rate that will accompany it. Symmetrically, negative interest rates should be associated with negative inflation. But that, for obvious political reasons, is counter to the norm and has almost never been sustained for long periods of time. That's why positive interest rates are the historical norm. We are indebted to conservative Switzerland for pointing the way to naturally negative interest rates. To their own surprise, the Swiss accomplished it by consistently maintaining the strongest paper currency in the world.

Many Fed critics resist negative interest rates on the grounds that they are inherently unnatural. This view is incomplete, as it misses the connection with deflation. True, negative rates can result from ever more strenuous efforts by central banks to force down their interest-rate targets. That is what weak-currency regimes like the euro zone and, most recently, Japan, are up to. In that context, negative rates really are unnatural - just a little bit more unnatural than zero rates. But it's not the only possible context. Negative rates can also result from market forces. Whatever script the Euroland and Japan are following, countries like Switzerland whose currencies appreciate consistently are starring in a different movie. There, negative rates are natural and deserve to be welcomed.

One such country could be the United States. Americans may not realize it, but they are in the Swiss camp. It's true that headline data don't show deflation in the US, at least as yet. That's partly because the CPI has been cauterized to make inflationary or deflationary surprises nearly invisible. In the commodities domain, and in other liquid markets, prices have been falling for three or four years thanks to the strong dollar. In that limited but vital sense, our inflation rate is already negative. With or without the Fed, negative interest rates are on the US horizon too.


David Ranson is the president and head of research at HCWE & Co., a research company now based in California.

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