the FOMC would have to reduce the funds rate to -5% by the end of this year—well below its lower bound of zero

TO BE NOTED: From Greg Mankiw:

"More on Negative Interest Rates From Glenn Rudebusch of the San Francisco Fed:

The recommended future policy setting of the funds rate based on the estimated historical policy rule and these economic forecasts is given as the dashed line in Figure 2. This dashed line shows that, in order to deliver a degree of future monetary stimulus that is consistent with its past behavior, the FOMC would have to reduce the funds rate to -5% by the end of this year—well below its lower bound of zero."

And:

"FRBSF Economic Letter

2009-17; May 22, 2009

The Fed's Monetary Policy Response to the Current Crisis

• Interest rate actions and enhanced communications
• Fed's balance sheet actions
• Summary
• References

Download and Print PDF Version (133KB)
Download data file (Excel file)

---

The global financial market turmoil that started in August 2007 has been followed by a severe economic downturn. Indeed, the U.S. economic recession is on track to be the longest and deepest of the postwar period. This Economic Letter describes the Federal Reserve's monetary policy response to this financial and economic crisis. A key element of this response has been a reduction of the federal funds rate—the Fed's usual monetary policy instrument—essentially to its lower bound of zero. Still, with the economy continuing to slump, additional stimulus appears warranted, and the Federal Open Market Committee (FOMC 2009) has promised to "employ all available tools to promote economic recovery and to preserve price stability." Therefore, the Fed has eased financial conditions by employing a variety of unconventional monetary policy tools that alter the size and composition of its balance sheet. It has also communicated more explicitly its expectations for the course of monetary policy and the economy in order to help guide households and businesses during these uncertain times.

Interest rate actions and enhanced communications

As shown in Figure 1, over the past two decades, the Fed has set the federal funds rate, a key gauge of the stance of monetary policy, in a fairly consistent fashion relative to various economic indicators such as unemployment and inflation. (Figure 1 shows the quarterly average funds rate and unemployment rate, and the four-quarter inflation rate for prices of core personal consumption expenditures. See the related data file.) During the current and two previous recessions—around 1991, 2001, and 2008—the Fed responded to large jumps in unemployment with aggressive cuts in the funds rate. In addition, episodes of lower inflation also were generally associated with a lower funds rate.

A rough guideline for setting the federal funds rate that captures the Fed's behavior over the past two decades is provided by a simple equation that relates the funds rate to the inflation and unemployment rates. This equation is obtained by a statistical regression of the funds rate on the inflation rate and on the gap between the unemployment rate and the Congressional Budget Office's estimate of the natural, or normal, rate of unemployment. The resulting empirical policy rule of thumb—a so-called Taylor rule—recommends lowering the funds rate by 1.3 percentage points if core inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point. As shown in Figure 2, this simple rule of thumb captures the broad contours of policy over the past two decades. Differences between the recommended target rate from the estimated policy rule (the thin line) and the Fed's actual target funds rate (the thick line) are fairly small. Exceptions occurred during the mid-1990s and mid-2000s, when the funds rate was set somewhat higher or lower than the policy rule recommended. During 2007 and 2008, by this rudimentary empirical metric, the Fed's lowering of the funds rate by over five percentage points was roughly in line with its historical behavior.

The estimated Taylor rule can also be used in conjunction with economic forecasts to provide a rough benchmark for calibrating the appropriate stance of monetary policy going forward. The dashed lines in Figure 1 show the latest forecasts for unemployment and inflation provided by FOMC participants—the Federal Reserve presidents and governors. (The dashed lines are quarterly linear interpolations of the median forecasts in FOMC, 2009.) Like many private forecasters, FOMC participants foresee persistently high unemployment and low inflation as the most likely outcome over the next few years. The recommended future policy setting of the funds rate based on the estimated historical policy rule and these economic forecasts is given as the dashed line in Figure 2. This dashed line shows that, in order to deliver a degree of future monetary stimulus that is consistent with its past behavior, the FOMC would have to reduce the funds rate to -5% by the end of this year—well below its lower bound of zero. Alternative specifications of empirical Taylor rules, described in Rudebusch (2006), also generally recommend a negative funds rate.

The shaded area in Figure 2 is the difference between the current zero-constrained level of the funds rate and the level recommended by the policy rule. It represents a monetary policy funds rate shortfall, that is, the desired amount of monetary policy stimulus from a lower funds rate that is unavailable because nominal interest rates can't go below zero. This policy shortfall is sizable. Indeed, the Fed has been able to ease the funds rate only about half as much as the policy rule recommends. It is also persistent. According to the historical policy rule and FOMC economic forecasts, the funds rate should be near its zero lower bound not just for the next six or nine months, but for several years. The policy shortfall persists even though the economy is expected to start to grow later this year. Given the severe depth of the current recession, it will require several years of strong economic growth before most of the slack in the economy is eliminated and the recommended funds rate turns positive.

Economic theory suggests that it is useful for the Fed to communicate the likely duration of any policy shortfall. Monetary policy is in large part a process of shaping private-sector expectations about the future path of short-term interest rates, which affect long-term interest rates and other asset prices, in order to achieve various macroeconomic objectives (McGough, Rudebusch, and Williams 2005). In the current situation, the FOMC (2009) has noted that it "anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Other central banks have been even more explicit about the duration of low rates. For example, the central bank of Sweden has recently stated explicitly that it expects to keep its policy rate at a low level until the beginning of 2011. Rudebusch and Williams (2008) describe how such revelation of central bank interest rate projections may help a central bank achieve its policy goals.

Last February, FOMC participants also started to publish their long-run projections for output growth, unemployment, and inflation—in keeping with a trend toward greater transparency (Rudebusch 2008). Such long-run projections can help illuminate the FOMC's policy strategies and goals, and these revealed that most FOMC participants would like to see an annual inflation rate of about 2% in the longer run. Such an expression of a positive inflation objective may help prevent inflationary expectations from falling too low and forestall any excessive decline in inflation.

Fed's balance sheet actions

The size of the monetary policy funds rate shortfall has also caused the Fed to expand its use of unconventional policy tools that change the size and composition of its balance sheet. The Fed started to employ these balance sheet tools in late 2007 as unusual strains and dislocations in financial markets clogged the flow of credit. Typically, changes in the funds rate affect other interest rates and asset prices quite quickly. However, the economic stimulus from the Fed's cuts in the funds rate was blunted by credit market dysfunction and illiquidity and higher risk spreads. Accordingly, the Fed started to lend directly to a broader range of counterparties and against a broader set of collateral in order to enhance liquidity in critical financial markets, improve the flow of credit to the economy, and restore the full effect of the monetary policy interest rate easing.

Toward the end of 2008, the recession deepened with the prospect of a substantial monetary policy funds rate shortfall. In response, the Fed expanded its balance sheet policies in order to lower the cost and improve the availability of credit to households and businesses. One key element of this expansion involves buying long-term securities in the open market. The idea is that, even if the funds rate and other short-term interest rates fall to the zero lower bound, there may be considerable scope to lower long-term interest rates. The FOMC has approved the purchase of longer-term Treasury securities and the debt and mortgage-backed securities issued by government-sponsored enterprises. These initiatives have helped reduce the cost of long-term borrowing for households and businesses, especially by lowering mortgage rates for home purchases and refinancing.

In terms of overall size, the Fed's balance sheet has more than doubled to just over $2 trillion. However, this increase has likely only partially offset the funds rate shortfall, and the FOMC has committed to further balance sheet expansion by the end of this year. Looking ahead even further over the next few years, the size and persistence of the monetary policy shortfall suggest that the Fed's balance sheet will only slowly return to its pre-crisis level. This gradual transition should be fairly straightforward, as most new assets acquired by the Fed are either marketable securities or loans with maturities of 90 days or less. Still, any economic forecast is subject to considerable uncertainty. Some outside forecasters have warned of a deeper and more protracted recession, in which case, the monetary policy funds rate shortfall and the balance sheet expansion would be even larger and more persistent. In contrast, other analysts have argued that the Fed's growing balance sheet will lead to a resurgence of inflation (despite Japan's recent historical experience to the contrary of an increasing central bank balance sheet and falling inflation). With much higher inflation, the policy shortfall would be reduced and the Fed would need to shrink the size of its balance sheet and raise the funds rate earlier than suggested by Figure 2. Still, the Fed's short-term loans can be unwound quickly, and its portfolio of securities can be readily sold into the open market, so there should be ample time to normalize monetary policy when needed. Finally, some economists have cautioned about reading too much into policy shortfall projections (and negative funds rate recommendations) that rely on uncertain estimates of the degree of economic slack. Such considerations are always important for real-time policymaking (Rudebusch 2001, 2006), but the degree of uncertainty regarding estimates of the natural, or normal, rate of unemployment over the past two decades pales in size relative to the depth of the ongoing recession.

Summary

The Federal Reserve is employing all available tools to promote economic recovery and price stability by lowering borrowing costs and boosting credit availability. In particular, after lowering the federal funds rate to essentially zero, the Fed has turned to unconventional policy tools to help accomplish its goals. Eventually, as the economy recovers, it will be appropriate for the Fed to reduce the size of its balance sheet toward pre-crisis levels and to raise the funds rate, and the Fed has both the means and the determination to do so.

Glenn D. Rudebusch
Senior Vice President and Associate Director of Research

References

[URLs accessed May 2009.]

Federal Open Market Committee. 2009. "Minutes of the Federal Open Market Committee," April 28­-29.

McGough, Bruce, Glenn D. Rudebusch, and John C. Williams. 2005. "Using a Long-Term Interest Rate as the Monetary Policy Instrument." Journal of Monetary Economics 52, pp. 855-879.

Rudebusch, Glenn D. 2001. "Is the Fed Too Timid? Monetary Policy in an Uncertain World." Review of Economics and Statistics 83(2) (May) pp. 203-217.

Rudebusch, Glenn D. 2006. "Monetary Policy Inertia: Fact or Fiction?" International Journal of Central Banking 2(4) December, pp. 85-135.

Rudebusch, Glenn D. 2008. "Publishing FOMC Economic Forecasts." FRBSF Economic Letter 2008-01 (January 18).

Rudebusch, Glenn D., and John C. Williams. 2008. "Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections." In Monetary Policy and Asset Prices, ed. John Campbell. Chicago: University of Chicago Press, pp. 247-284."

nothing at all strange about a world in which you put a dollar in a deposit account and get back 95 cents after a year

From Willem Buiter:

"Negative interest rates, Sharia law and tech stocks

May 20, 2009 9:57am

Morality

I know of ethical systems that hold all interest to be sinful. Riba, interest on money, is forbidden by the Quran. I don’t know what Sharia scholars would have to say about negative nominal interest rates. If if were viewed as a gift from the lender to the borrower it might even be condoned. Perhaps an extra-credit question on the next Islamic finance examination? Medieval Christianity also banned ‘usury’, which meant any ‘interest’ rather than outrageous interest rates - its modern meaning.

Interest is viewed by some as immoral because it represents an increase in capital without any services being provided. I don’t share the sense of moral outrage at interest per se, but I can understand where it comes from - something for nothing ain’t right. However, I know of no ethical system that attaches opprobrium to an intertemporal relative price that is greater than unity but not to an intertemporal relative price that is less than unity - or vice versa.

Apparently, there are those who believe that when the price today of one unit of money tomorrow is less than one unit of money now - when the nominal interest rate is positive - there is no moral issue. When the price today of one unit of money tomorrow is more than one unit of money now - when the nominal interest rate is negative - something nasty is being perpetrated. No matter how I shake and bake this set of beliefs, I cannot make sense of it.

Equity, high tech or other

Would the temptation/urge to escape into equity (high-tech, low-tech or no-tech) should the short nominal rate of interest become negative would make a negative nominal interest rate policy infeasible? Obviously not. Below I have scribbled the standard portfolio balance or equilibrium condition that must be satisfied if an investor is will to hold both short nominal bonds with a nominal interest rate i and equity with a dividend per share d, a current share price q, an expected future share price Eq and an equity risk premium π . The risk premium can be given economic content (I won’t bother with that here). It is not whatever is required to make the relationship hold identically.

What this means is that (holding the equity risk premium constant for the sake of argument), a negative nominal interest rate, for a given positive dividend yield, requires the expectation of falling equity prices. This is less counter-intuitive if you replace ‘falling equity prices’ by ‘high but falling equity prices’. So negative nominal interest rates and tech stocks can coexist peacefully. The price today of one dollar of money tomorrow can be a dollar and five cents, that is, i = -0.05. Most economics I know breaks down only if the price today of one dollar of money tomorrow,

, were to become infinite or to become negative (i goes to -1 from above). This would mean a nominal interest rate of minus 100 percent or more. It would be a strange world if you put 1 dollar in a deposit account and after a year got back nothing or a demand for payment. But there is nothing at all strange about a world in which you put a dollar in a deposit account and get back 95 cents after a year. With a bit of luck, we may even get used to having such a state of affairs prevail from time to time."

Me:

Since I've studied the Talmud on some of these issues, I'm going to leave the religious question aside. However, via Zero Hedge, I came upon the following excellent post that gives a version of the ideas I agree with:

http://www.american.com/archive/2009/may-2009/why-not-negative-interest-rates/article_print

"Would anybody rationally pay $1.02 for $1.00 in cash? They do today, if they take cash as a non-customer from an ATM. The average ATM surcharge fee is about $2. For a $100 withdrawal, that is equivalent to a price of $1.02. Alternately thought of, if a $200 withdrawal were cash for one month, the average fee would be equivalent to a negative 12% interest rate.

In general, the increasing dependence on electronic payments makes a massive move to currency less feasible and thus negative interest rates more plausible."

Read the whole post. And, of course, there's this, via Hugo, wherever he is:

http://www.chiemgauer.info/

I have to say, the idea that you would place a disincentive on flight to quality panic buying makes perfect sense to me. Since it is, in some sense, equivalent to inflation, I can only guess that people would rather not notice that their assets have been devalued. Calling Erich Fromm! Posted by: Don the libertarian Democrat

received more hate mail from my NY Times article on the topic than from anything else I have ever written

TO BE NOTED: From Greg Mankiw's Blog :

"More on Negative Interest Rates From LSE economist (and former central banker) Willem Buiter, who concludes

Removing the zero lower bound on nominal interest rates would represent a valuable addition to the policy arsenal of the central banks. We know something about how interest rates work. There is no reason to believe there would be any dramatic change in the effectiveness of policy rate cuts if these cuts to the rate [are to a] level below zero. We know next to nothing about the effectiveness of the alternative policies that central banks are forced to adopt if they don’t just want to sit on their hand[s] once the[y] hit the zero lower bound: quantitative easing and credit easing, relaxing the collateral requirements for central bank lending etc.

I should note that, economic logic aside, the "optics" of negative interest rates are not very good. I received more hate mail from my NY Times article on the topic than from anything else I have ever written. Indeed, Harvard University President Drew Faust received several emails suggesting that I be fired for writing the piece. She graciously copied me on her replies, which noted that Harvard faculty are not sacked for espousing controversial ideas. Central bankers, however, do not enjoy the same luxury."

It would be administratively costly and unpleasantly intrusive. This may well endear the notion to our governments.

From Willem Buiter:

"Negative interest rates: when are they coming to a central bank near you?

May 7, 2009 2:27am

The problem

I agree with Greg Mankiw[1] that it is time for central banks to stop pretending that zero is the floor for nominal interest rates. There is no theoretical or practical reason for not having the Federal Funds target rate and market rates at, say, minus five percent, if that is what your Taylor rule, or whatever heuristic guides your official policy rate, suggests.

Economics as a science and economic reality have never had problems with negative real (inflation-adjusted) interest rates. So what is the problem with nominal rates? In a word, it’s currency.

Financial instruments can be categorised as bearer instruments (bearer securities) or registered instruments (registered securities). Bearer instruments are instruments for which the issuer does not know the identity of the owner. So, unless you can prove the opposite (after a mugging say), the holder or bearer is the owner - possession is most of the law. Currency is an example of a bearer instrument. It is a negotiable bearer bond - it is transferable to another party by delivery. And it does not have to be endorsed by the party transferring it. Many bonds are bearer securities as well, but through a variety of arrangements (including clipping coupons in the old days) it has been possible to get over the problem of paying interest on these non-currency bearer instruments.

Registered securities or instruments are securities or instruments where the issuer knows the identity of the owner. Shares are an example, so are bank accounts and reserves held by banks with the central bank. Paying interest, negative or positive, on registered instruments is trivial. In many cases today interest payments are entries in some electronic ledger. When I get a positive five percent annual interest rate on my deposit account, I put in $100 and get out $105 a year later. When I get a negative five percent interest rate, I put in $100 and get out just over $95 one year later. The same holds for bonds. I issue a one-year zero-coupon bond with a minus five percent interest rate and a year later I repay my creditors just $95 for every $100 borrowed through bond issuance.

Central banks have no problem whatsoever paying negative interest rates on deposits (reserves) held by banks with them. Neither is it any more difficult to charge a negative interest rate on collateralised borrowing by commercial banks from the central bank than it is to charge a positive interest rate. If there are Millennium-Bug-style problems with programs and spreadsheets that take the logarithm of a nominal interest rate (rather than the logarithm of one plus the interest rate, as any sensible person would have coded it), it’s time to do some overtime correcting such silly ‘technical’ obstacles to negative interest rates. The brainless should not be in banking.

Currency is the only problem. Paying positive interest on currency is difficult because you don’t know the identity of the owner. The same note could be presented repeatedly to earn the interest due for a single period. To get around this problem, the instrument itself must be clearly identified as current or non-current on interest. Once interest has been paid, it is marked, traditionally by stamping it or by clipping a coupon off it.

With negative interest, the problem is not the owner turning up too often to claim his interest. It is getting him to turn up at all. Since the authorities don’t know I am the owner of the currency I own, why should I volunteer to pay the government money for the privilege?

It is this prima facie trivial obstacle of paying negative interest on currency that has prevented central banks from breaking through the lower floor (no stories about Switzerland, please).

Stricly speaking this story must be qualified in minor ways. If currency is the most liquid security, no other risk-free nominal instrument can earn less than it, net of carry costs (costs of storage, safekeeping and insurance). Carry costs for currency are higher than for Treasury bills or reserves with the central bank. The zero lower bound is therefore, strictly speaking a lower bound somewhat below zero. But not enough to achieve a minus five percent Federal Funds target rate.

Fortunately, it turns out to be extremely simple to remove the zero lower bound on short, risk-free nominal interest rates.

Solutions

There are three practical ways to implement negative nominal interest rates.

(1) Abolish currency. This is easy and would have many other benefits. The main drawbacks would be the loss of seigniorage income to the central bank. There may be a ‘millennium bug’ type transitional problem, if a lot of bad programmers have written code that blows up when the nominal interest rate hits zero (taking the logarithm of zero or of a negative number has interesting consequences), but all that means is a couple of wasted weekends at the office re-writing the relevant code.

Advanced industrial countries can move to electronic and bank-account-based means of payment and media of exchange without like problem. Negative interest rates on bank accounts and on balances outstanding on ‘centralised or networked electronic media’ like credit cards are as easy as positive interest rates. Debit cards simply transfer money between two accounts, both of which could pay negative interest rates and don’t pose a problem. You could even retain a measure of anonymity and have ‘cash-on-a-chip cards’, which, whenever the balance on the card is replenished by drawing funds from some account, calculate the average balance held on the cash card since the last replenishment and arrange for the appropriate interest rate (positive or negative) to be applied.

The only domestic beneficiaries from the existence of anonymity-providing currency are the criminal fraternity: those engaged in tax evasion and money laundering, and those wishing to store the proceeds from crime and the means to commit further crimes. Large denomination bank notes are an especially scandalous subsidy to criminal activity and to the grey and black economies. There is no economic justification for $50 and $100 bank notes, let alone for the €200 and €500 bank notes issued by the ECB. When asked why the ECB subsidises and encourages crime by issuing these large-denomination notes, the answer comes back that Spaniards like to make large transactions in cash, and that the ECB does not want to be responsible for an increased incidence or herniated discs, caused by people having to schlep large suitcases filled with small bills to make their next home purchase. There is an answer to that answer: kvatsch!

For foreigners in developing countries and emerging markets with high-inflation-prone monetary systems, the disappearance of the US dollar notes and the euro notes could be a setback, as these provide welcome stores of value when domestic inflation rages. It has been estimated that as much as 70 percent of all US dollar bills (by value) are held outside the USA (not all by people wanting to hedge against hyperinflation at home, of course) and that up to 50 percent of all euro notes (by value) are held outside the Euro Area. To those people I would say, I feel your pain, but this is the time to replace exit with voice. Go and create a polity that will support a government that does not abuse the printing presses.

As a concession to the poor, we could keep a limited number of 1$ and 5$ bills (1€ and 2€ coins and 5€ bills) in circulation. I cannot envisage banks and other big financial players would wish to store warehouses full of small bills). If the small bills were not supplied on demand, but had their quantity exogenously determined, my option 3 below would be likely to kick in. The remaining dollar bank notes would not exchange at par with dollar deposits, dollar cash-on-a-chip or other dollar e-money, but would trade at a varying relative price (exchange rate) vis-a-vis these other, negative interest-bearing means of payment and media of exchange. The depreciation of this exchange rate would make traders and portfolio holders indifferent between holding zero interest currency and negative interest bank deposits.

My good friend and colleague Charles Goodhart responded to an earlier proposal of mine that currency (negotiable bearer bonds with legal tender status) be abolished that this proposal was “appallingly illiberal”. I concur with him that anonymity/invisibility of the citizen vis-a-vis the state is often desirable, given the irrepressible tendency of the state to infringe on our fundamental rights and liberties and given the state’s ever-expanding capacity to do so (I am waiting for the US or UK government to contract Google to link all personal health information to all tax information, information on cross-border travel, social security information, census information, police records, credit records, and information on personal phone calls, internet use and internet shopping habits).

But given the fact that e-money that can pay positive or negative interest without any additional cost can now be made available to all, in the advanced (post-) industrial countries, and given that even traditional bank accounts, credit cards and debit cards can take care of most of the retail payment system without creating a zero lower bound constraint on nominal interest rates, we really don’t need cash to facilitate trade and commerce. It is a redundant, indeed dominated medium of exchange and means of payment for legitimate transactions. Do we really want to retain cash just because it (1) allows us to hide some of our legitimate financial transactions from the government (as insurance against government abuse of the information), and (2) is a source of revenue to the central bank? These arguments pro are surely dominated by the two arguments against currency, (1) that, as currently construed (but see my third way of removing the lower bound), currency imposes a zero lower bound on nominal interest rates and (2) that it subsidises the grey and black economies and makes life easier for the global criminal and terrorist fraternity.

Instead of abolishing currency altogether, we could only issue low denominations, say nothing larger than $5 or €5. The carry costs (safe-keeping, insurance and storage) for large amounts of cash are likely to become prohibitive if you have to do it all in fivers. The zero lower bound would be likely to shift to a significantly negative lower bound.

(2) Tax currency and ‘stamp’ it to show it is ‘current on interest due’. This is Silvio Gesell’s proposal, supported by Irving Fisher and re-introduced into the policy debate by Marvin Goodfriend and by myself and Nikolaos Panigirtzoglou.[2] When the interest rate on currency is positive, the currency must be marked (by stamping or clipping coupons) to make sure the (anonymous) bearer does not present it repeatedly for the payment of interest. When the interest rate is negative, the (anonymous) bearer must (a) be induced to come forward to receive his negative interest (i.e. pay interest to the central bank) and (b) must be able to demonstrate that the negative interest has been received. To ensure (b), the currency must again be stamped or marked (electronically tagged). To get the bearer to come forward to pay the negative interest we can either rely on honesty and a sense of patriotic duty, or we can impose sanctions for non-compliance. I am afraid penalties for non-compliance (fines, a day in the stocks) would be required to make negative interest on currency work. This would require random checks etc. It would be administratively costly and unpleasantly intrusive. This may well endear the notion to our governments.

(3) Unbundle currency from the unit of account. This ideal goes back at least to Eisler (1932), was drawn to my attention by Stephen Davies in 2004 and has been formalised by me in a couple of papers since then.[3] The basic idea is simple. In an economy where the dollar is the unit of account for price and wage contracts and most other market transactions, the fact that the currency is also the dollar (that is, the fact that X dollars worth of currency purchases X dollars worth of short-term nominal public debt (or X dollars worth of reserves with the central bank) establishes a zero lower bound on the nominal interest rate (what matters is that the exchange rate of currency and short nominal debt is constant, not that it is unity).

Now abolish the dollar currency and introduce a new currency, the rallod. The exchange rate between the rallod and the dollar is not constant. It can either be determined by the government or let by the market. In the first case, the government (central bank) supplies rallod on demand at the government-determined exchange rate; in the second case, the stock of rallod currency is exogenous (determined by the government but not available from the government in whatever quantity demanded at a given exchange rate. Since the rallod is the currency, there is a zero lower bound on the rallod interest rate on rallod-denominated securities (I am ignoring carry costs and assume that solution 2 is not applied to the rallod). However, since there no longer is dollar currency, the nominal interest rate on dollar securities can be negative as easily as it can be positive.

Let S_t be the spot exchange rate between the dollar and the rallod in period t (number of rallods per dollar), F_t+1,t the forward exchange rate between the dollar and the rallod in period t, i_t+1,t the one period interest rate on safe dollar securities and i*_t+1,t the one-period interest rate on safe rallod securities. No arbitrage implies that these four variables are related through covered interest parity (CIP):

As long as the interest rate on rallod securities is positive, it does not matter what the spot and forward exchange rates between the dollar and the rallod are. Assume that we hold the spot exchange rate constant and keep the forward rate equal to the spot rate. This means, from CIP, that dollar interest rates are the same as rallod interest rates.

Now assume that both interest rates would have to go below zero if the monetary authority were to follow its Taylor rule, or whatever heuristic for driving the policy rate that floats its boat. The rallod interest rate is constrained to be non-negative and therefore equals zero. However, the dollar interest rate is set at whatever negative value the central bank thinks best - minus five percent, say. Can the dollar interest rate be - 0.05 and the rallod interest rate 0.00 without this creating opportunities for pure profits - a certain positive payoff without putting any money at risk? It can provided the forward price of the dollar in terms of the rallod is five percent higher than the spot price. This follows straight from the CIP condition above. With i_t+1,t = - 0.05 and i*_t+1,t = 0.00, the no-arbitrage condition is satisfied provided S_t/F_t+1,t = 0.95. If the authorities announce a path for the future spot exchange rate that is perfectly credible, the forward rate will be equal to the expected (and actual) future spot rate. Let E_t denote an expectation or anticipation formed at time t, then, with perfect credibility, F_t+1,t = E_tS_t+1 = S_t+1. In this case there is uncovered interest parity (UIP) as well as covered interest parity.

UIP

The monetary authority has three instruments in the rallod currency world: the interest rate on dollar securities (the central bank’s official policy rate), the spot exchange rate of the dollar and the rallod and the forward rate. Given these three, the interest rate on rallod securities follows (subject of course, to the non-negativity constraint on rallod interest rates.

The zero lower bound on dollar interest rates has been removed. It has been replaced by a zero lower bound on rallod interest rates, but these don’t matter, as it is the dollar general price level that matters, and the dollar is the numéraire/unit of account.

Those who want to work through these things will note that, if there is UIP, real interest rates (inflation corrected interest rates) will be the same on nominal dollar bonds as on nominal rallod bonds. This is because the law of one price implies that the dollar price level, P, say, is related to the rallod price level, P^*, say, by the law of one price, that is

PS = P*

Even though dollar and rallod real interest rates are the same, the creation of the rallod and the unbundling of the medium of exchange/means of payment and the numéraire/unit of account makes a real difference to the behaviour of the economy and the effectiveness of monetary policy, whenever there is any probability that the zero lower bound would become binding in the dollar currency economy. In that case, in the rallod currency economy, dollar real interest rates and rallod real interest rates will be equal to each other, but they are different from what they would have been in the dollar economy.

What can go wrong? The only thing that can go wrong is that the dollar would cease to be the numéraire for key private contracts (especially wage and price contracts) when the dollar is replaced by the rallod as the currency. If that were to happen, if the numéraire ‘followed the currency’, the price level that matters is the rallod price level, not the dollar price level. We would be back in the dollar currency economy, simply having renamed the dollar the rallod. This would be a currency reform of the kind that replaced 100 old French francs with 1 new French franc.

The numéraire is not chosen by the monetary authority or by the government. It is the outcome of an uncoordinated social decision process. Sometimes multiple numéraire have coexisted. But while the authorities cannot legislate the numéraire, they can strongly encourage the use of a specific numéraire. In the rallod currency economy, the government can insist that all contracts in and with the public sector be denominated in dollars. They can require tax returns to be made using the dollar as numéraire, and they can insist that taxes be paid with dollar deposits or other dollar-denominated (non-currency) means of payment. They can discourage or ban the creation of checkable accounts denominated in rallods, etc. etc.

So I have little doubt that the rallod currency economy could be nudged towards retaining the dollar as the numéraire in systemically important contracts and transactions. So the zero lower bound that matters would have been removed.

After this good news, the better news. It isn’t even necessary to abolish the dollar currency and replace if by the rallod currency. You can keep the dollar currency. All that is required is that the authorities no longer maintain a fixed exchange rate (equal to 1) between bank reserves with the central bank and currency. Instead they let the exchange rate between dollar reserves with the central bank and dollar currency, S_t, be market-determined. The authorities of course can no longer supply dollar currency on demand (or take it back on demand) at a fixed exchange rate (currently 1) with bank reserves with the central bank. Instead they determine the stock of currency dollars exogenously.

So the authorities have two instruments in the floating exchange rate case: the dollar interest rate and the quantity of dollar (or rallod) currency it issues. The remaining degree of freedom has to be provided by a terminal condition for the exchange rate in the long run. Speculative bubbles could arise in this market, if the exchange rate is left to float.

With a floating exchange rate between the reserve dollar and the currency dollar, UIP will not in general hold. Instead we have an equilibrium relationship, shown below, that says, effectively, that the interest-rate differential between the reserve dollar and the currency dollar equals the expected proportional rate of depreciation of the reserve dollar vis-a-vis the currency dollar plus an exchange rate depreciation risk premium, as shown below.

So a reserve dollar would no longer automatically be worth a currency dollar. If that is confusing, call the currency dollar the rallod instead.

I gave a lecture on these issues at the Center for Financial Studies of the Goethe University in Frankfurt, Germany, today. Otmar Issing was in the audience. He listened carefully (he always does) and gave me quite a grilling during dinner afterwards. I don’t think I have convinced him yet of the merits of the case for breaking through the zero lower bound on nominal interest rates, but here’s to hoping! The Powerpoint slides of the presentation can be found here.

Conclusion

Removing the zero lower bound on nominal interest rates would represent a valuable addition to the policy arsenal of the central banks. We know something about how interest rates work. There is no reason to believe there would be any dramatic change in the effectiveness of policy rate cuts if these cuts to the rate level below zero. We know next to nothing about the effectiveness of the alternative policies that central banks are forced to adopt if they don’t just want to sit on their hand once the hit the zero lower bound: quantitative easing and credit easing, relaxing the collateral requirements for central bank lending etc.

All these alternative measures also blur the distinction between the responsibilities of the monetary and the fiscal authorities. It undermines central bank independence, something which, up to a point, I consider valuable.

There are at least three ways to remove the zero lower bound that are feasible: abolish currency, tax currency and ensure that currency is not the numéraire. Taxing currency may be awkward and intrusive, but abolishing currency is not just easy (just do it) but also has considerable advantages as a blow against criminality and terrorism. Unbundling currency and numéraire is something that can be done over the weekend.

I really don’t understand why central banks are not aggressively pursuing options for removing the zero lower bound. It is that they love the seigniorage so much? But they retain seigniorage revenue from currency issuance in the rallod economy. Is it hidebound conservatism and lack of imagination. Quite possibly. But if so, this is a costly mistake. Central banks should act to remove the zero lower bound on nominal interest rates now.

---

[1] N. Gregory Mankiw (2009) “It May Be Time for the Fed to Go Negative”, in: New York Times April 18

[2] Goodfriend, Marvin (2000), “Overcoming the Zero Bound on Interest Rate Policy“, in: Journal of Money, Credit, and Banking, Vol. 32(4)/2000, S. 1007 - 1035.

Buiter, Willem H. and Nikolaos Panigirtzoglou (2001), “Liquidity Traps: How to Avoid Them and How to Escape Them”, with Nikolaos Panigirtzoglou, in Reflections on Economics and Econometrics, Essays in Honour of Martin Fase, edited by Wim F.V. Vanthoor and Joke Mooij, , pp. 13-58, De Nederlandsche Bank NV, Amsterdam.

Buiter, Willem H. and Nikolaos Panigirtzoglou (2003), “Overcoming the Zero Bound on Nominal Interest Rates with Negative Interest on Currency: Gesell’s Solution”, Economic Journal, Volume 113, Issue 490, October 2003, pp. 723-746.

[3] Buiter, Willem H. (2004) ,”Overcoming the Zero Bound: Gesell vs. Eisler; Discussion of Mitsuhiro Fukao’s “The Effects of ‘Gesell’ (Currency) Taxes in Promoting Japan’s Economic Recovery” . Discussion presented at the Conference on Macro/Financial Issues and International Economic Relations: Policy Options for Japan and the United States, October 22-23, 2004, Ann Arbor, MI, USA. International Economics and Economic Policy, Volume 2, Numbers 2-3, November 2005, pp. 189-200. Publisher: Springer-Verlag GmbH; ISSN: 1612-4804 (Paper) 1612-4812 (Online).

Buiter, Willem H. (2007), “Is Numérairology the Future of Monetary Economics? Unbundling numéraire and medium of exchange through a virtual currency with a shadow exchange rate”, Open Economies Review, Publisher Springer Netherlands; ISSN 0923-7992 (Print); 1573-708X (Online). Electronic publication date: Thursday, May 03, 2007. See “Springer Website”.

Davies, Stephen [2004], “Comment on Buiter and Panigirtzoglou”, mimeo, Research Institute for Economics and Business Administration, Kobe University, May.

Eisler, Robert (1932), Stable Money: the remedy for the economic world crisis: a programme of financial reconstruction for the international conference 1933; with a preface by Vincent C. Vickers. London: The Search Publishing Co."

Me:

"(2) Tax currency and ‘stamp’ it to show it is ‘current on interest due’."

I'm for Stamping. It was also defended and commented upon in the FT here:

http://blogs.ft.com/economistsforum/2008/11/the-case-for-negative-interest-rates-now/#more-259

The case for negative interest rates now
November 20, 2008 12:35pm
by FT

By Brendan Brown

A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum.

These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels.

In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?...... "

Excellent comment by Martin Wolf:

" Martin Wolf: This is ingenious and would, no doubt, permit negative real interest rates. But I would prefer it if vigorous action were taken by the monetary authorities to sustain inflation, before deflation set it, in which case we would never need negative nominal interest rates in order to obtain negative real rates.

If it is already too late for this, I agree that this scheme would make it possible for the authorities to impose negative real short rates. Another justification for negative real rates is that it would reduce the danger of debt deflation - the rising real level of debt as the price level falls. It would be wildly unpopular, of course, among politically powerful savers. It would have to be pointed out that this loss is offset by the rising real value of nominal claims.

But would it work in the way Brendan suggests? I am not sure. Equity markets might rise a little. But I very much doubt whether companies would start to issue equity in order to invest in a substantial way, in the midst of a deep recession. The underlying logic is Hayekian. I have never been convinced of this theory of the credit cycle.

So is there an alternative? Yes. The central bank can lend directly to the government, which can spend on investment and public consumption or make transfers to consumers to spend. If real interest rates were negative, this would be even cheaper for the government. That would certainly add to the effectiveness of such a policy, in any case.
Posted by: Martin Wolf"

Both Nick Rowe and Scott Sumner have good points against Stamping, but I find it simple and effective. I'm less concerned on the method used, than on the use of the concept. Brad De Long has also commented on it recently:

http://delong.typepad.com/sdj/2009/04/silvio-gesell-and-stamped-money-another-thing-fisher-and-wicksell-knew-that-modern-economists-have-forgotten.html

But Silvio Gesell is the topic of part VI of chapter 23 of Keynes's flagship work, The General Theory of Employment, Interest and Money. And it's not just Keynes in his flagship work. There are 55,000 google hits for "Silvio Gesell." Patinkin (1993) reports that Irving Fisher advocated Gesell-based "velocity control" in his 1932 Booms and Depressions. Nobel prize-winning Maurice Allais was an advocate as well. Gerardo della Paolera and Alan Taylor are Gesell's biggest boosters today in their book Straining at the Anchor: The Argentine Currency Board and the Search for Macroeconomic Stability, 1880-1935, a University of Chicago Press book that is part of the NBER's series on "long term factors in economic development." Willem H. Buiter and Nikolaos Panigirtzoglou writing in the Economic Journal in 2003: "Overcoming the Zero Bound on Nominal Interest Rates with Negative Interest on Currency: Gesell's Solution."

This is, I think, yet another example of how much economics has lost by cutting itself off from its moral philosophical and historical roots. Something that Keynes and Fisher and the other founders of monetary economics seriously wrestled with is today seen as something unknown and new to be thought of by clever graduate students. Once again the answer to Olivier Blanchard's question "What Do We Know that Fisher and Wicksell Did Not?" is that Olivier is asking the wrong question: what did they know that we have forgotten?

Here is John Maynard Keynes writing in 1936, summarizing Silvio Gesell writing in 1916:

J.M. Keynes, General Theory of Employment, Interest and Money, chapter 23: It is convenient to mention at this point the strange, unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight.... [T]he English version (translated by Mr Philip Pye) being called "The Natural Economic Order". In April 1919 Gesell joined the short-lived Soviet cabinet of Bavaria as their Minister of Finance, being subsequently tried by court-martial.... Professor Irving Fisher, alone amongst academic economists, has recognised its significance. In spite of the prophetic trappings with which his devotees have decorated him, Gesell's main book is written in cool, scientific language; though it is suffused throughout by a more passionate, a more emotional devotion to social justice than some think decent in a scientist.... I believe that the future will learn more from the spirit of Gesell than from that of Marx.... Gesell's specific contribution to the theory of money and interest is... that the peculiarity of money, from which flows the significance of the money rate of interest, lies in the fact that its ownership as a means of storing wealth involves the holder in negligible carrying charges.... [H]e had carried his theory far enough to lead him to a practical recommendation, which may carry with it the essence of what is needed... the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of 'stamped' money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher.... [C]urrency...would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps... should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per week, equivalent to 5.2 per cent per annum.... The idea behind stamped money is sound..."

It would be wonderful if this idea was seriously considered.

"Taxing currency may be awkward and intrusive"

This is easily the most effective proposal, since it fits into our system of government. Posted by: Don the libertarian Democrat

And:

The point of stamping, in my view, is to give a disincentive to buying bonds in a Debt-Deflationary situation. In other words, when investors are driving down yields in a panic in the flight to safety and liquidity, you tempt them to put their money into other assets, like stocks or corporate bonds or helping a friend start a business.

It makes sense to me to invest in stocks when the market is low and you are getting nothing in return for buying bonds. Then, when bond yields go up, you buy bonds. That's why some inflation in the future is a good sign.

QE can work as well, and so read this:

http://ftalphaville.ft.com/blog/2009/05/07/55605/the-qe-stockmarket-effect/?source=rss

"But, as Lewis also points out, QE may be having another, perhaps less expected, but nonetheless still very welcome effect - on equities. As he explains (our emphasis):
Possibly, the chief impact of QE will come through the equity market. If ‘other financial institutions’ see their bank deposits increasing, they may be inclined to commit some of these funds to equity investment. "

In my view, with low yields on short term bonds, and gradually increasing yields on longer term bonds, this result is expected. Posted by: Don the libertarian Democrat

But there are worse things than inflation. And guess what? We have them today.

TO BE NOTED: From the NY TIMES:

"It May Be Time for the Fed to Go Negative

By N. GREGORY MANKIW

WITH unemployment rising and the financial system in shambles, it’s hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I’m not talking about attitude. I‘m talking about numbers.

Let’s start with the basics: What is the best way for an economy to escape a recession?

Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

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.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell’s concern about cash hoarding suddenly seems very modern.

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. Even children can be taught that some problems (such as 2x + 6 = 0) have no solution unless you are ready to invoke negative numbers.

Maybe some economic problems require the same trick.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush."

The proposal for negative interest on reserves that Bill Woolsey and I have been discussing for months

From The Money Illusion:

"Krugman on negative insider trading

If markets are efficient then the expected loss on Fed purchases of long term debt is roughly zero. On the other hand if the Fed has inside information about its future policy, then the Fed could use that information to make expected profits or losses. In a post today, Krugman argues that the Fed may be using the inside information in a perverse way, to generate expected losses. His argument (which is technically correct and which I discussed here in an earlier post) is that the Fed might actually persevere and produce more inflation (and I would add more real spending growth as well) than the markets currently expect. Because markets are skeptical about the ability or willingness (probably the latter) of the Fed to carry through on a reflationary policy, long bond yields do not currently price in the sort of inflation or nominal spending growth that the Fed presumably wants. What do we make of this?

1. My initial thought a few weeks ago was that the Fed should buy assets that are likely to appreciate if they are successful, which they would insure by announcing a nominal target and doing whatever was necessary to hit the target. Who cares if traders who doubted the Fed’s word lose money? It’s a good way to build credibility.

2. The Fed may think my idea is too risky, and they may be right. The markets may actually know the Fed better than it knows itself. I.e. the markets may be able to predict future Fed behavior better than the Fed. Think of the Fed as like a powerful but lumbering woolly mammoth, surrounded by agile saber-tooth tigers. The markets are very good at sensing which policy targets are credible. In Japan, the markets correctly sensed that the BOJ’s promise to end deflation was a sham, and deflation got priced into bond yields. And they were right; the BOJ tightened policy twice while deflation was still occurring.

3. Neither Krugman nor Bernanke seems to have noticed yet that we could get by with far less QE than is currently being discussed. The proposal for negative interest on reserves that Bill Woolsey and I have been discussing for months has finally been discovered by Harvard University (according to a recent post in Mankiw’s blog–and with a wacky idea for negative interest on cash that is not a part of our proposal here.) It would end the problem of excess reserve hoarding, which has been by far the biggest factor in boosting demand for base money (and hence limiting the effectiveness of QE.) Let’s see how long it takes for the idea to get to Princeton (Krugman and Bernanke’s University.)

4. On a serious note, I actually do agree with Krugman:

a. QE is worth trying.

b. By itself QE may not work (in my view due to positive interest on reserves.)

c. And if it does work it may expose the Fed to some capital losses.

The reason that I have been prodding people like Mankiw and Krugman in recent posts is to try to raise the visibility of the proposal for negative interest on excess reserves. I strongly believe this issue is important, and hope to attract the attention of someone who can publicize the issue much more effectively than I can."

Me:

1. Don the libertarian DemocratYour comment is awaiting moderation.
   20. March 2009 at 19:22

   Back in November, we had this post in the FT which I endorsed:

   http://blogs.ft.com/economistsforum/2008/11/the-case-for-negative-interest-rates-now/#more-259

   “The case for negative interest rates now
   November 20, 2008 12:35pm
   by FT

   By Brendan Brown

   A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

   The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

   If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

   The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

   Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum.

   These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels.

   In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

   There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

   Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

   These cues lead to the solution.

   The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new)…..”

   I don’t remember anyone being interested in this at the time.

   “Then, Interfluidity offered this:

   http://www.interfluidity.com/posts/1229908180.shtml#comments

   Since the current Fed loves bold and unorthodox action, I thought I’d end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them. If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)”

   Then, I asked Nick Rowe this:

   “Nick, I might ask something else, but this puzzles me:

   “because the domestic and foreign central banks want to push interest rates lower, but can’t.’

   I don’t understand why the Fed couldn’t”
   1) Add a fee to these bonds
   2) Discount them over time

   In other words, add a disincentive to buy and hold them.

   Posted by: Don the libertarian Democrat | February 03, 2009 at 04:51 PM

   Hi Don: it’s technically possible. But people would just hold cash under the mattress, or in safety deposit boxes, and get zero interest rates that way. (There are various schemes always floated to tax cash, or make it expire, etc., but they always come across as a bit sci-fi.)

   Posted by: Nick Rowe | February 03, 2009 at 05:27 PM”

   Are you advocating the same thing, or are these ideas somewhat different?

And:

Don, Thanks for the link, I need to link to that blog, as he has the same idea as I do. The FT idea of interest on cash, however, is probably a nonstarter. If I understand your idea, it is for negative rates on T-bills (once nominal rates had fallen to zero.) Is that right? If so, I am afraid that Nick Rowe is right, it wouldn’t work because of private currency hoarding. It is the same logic as my idea, and is a good idea, but here is the difference. The Fed cannot police the public and prevent them from hoarding cash as a way of avoiding negative rates. But the Fed can police commercial banks and prevent them from hoarding vault cash as a way of avoiding the tax on bank reserves.

"Was the negative yield on the three month T-Bill a wake up call to foreign investors that holding cash in Dollars is not a very attractive option?"

I mentioned Dollar's Decline earlier, here's a chart from Bespoke:

"While investors have been focused on the S&P 500 and its attempt to break through its 50-day moving average, the Dollar had no problems breaking through its 50-day. Unfortunately, the break was to the downside. With a decline of 1.5% today, the US Dollar index traded below its 50-day moving average for the first time since late July. At the same time the Dollar has been falling, the Euro has been rallying, as it broke above its 50-day moving average for the first time in months. Was the negative yield on the three month T-Bill a wake up call to foreign investors that holding cash in Dollars is not a very attractive option?

Not surprisingly, Gold is benefiting from the Dollar's weakness with a gain of 3% today. A look at this chart shows that the commodity is still nowhere near breaking its downtrend. However, it is currently trading right at a short-term resistance level of around $830. How it acts in the weeks and months ahead will be a good indication of how concerned the market is regarding inflation.

Subscribe to Bespoke Premium to receive more in-depth research from Bespoke.

"If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes."

Brendan Brown in the FT confronts this buying of basically interest free bonds:

"A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum."

So, you want interest rates to decline so that businesses, say, can borrow more cheaply, and hire workers, etc., in order to increase buying, and come out of a recession. But what happens when no one is buying and yet interest rates are as low as they can get.

Well, are there any incentives or disincentives to combat this problem, largely associated with the fear of risk and flight into safe investments, such as US Treasuries, that are guaranteed by the government? Now, it's important to understand that this is also an incentive.

One thing you can use are disincentives. Here's one:

"These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels."

So, this a purchase fee added onto the bond. How about taxes?

"In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

These cues lead to the solution."

Basically, change their price after being purchased.

"The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new).

In the interim, 1:1 conversion of banknotes into deposits would be suspended. Instead, a crawling peg would be established. At the start, the exchange rate between deposits and banknotes would be virtually 1:1. At the end it would be 0.9 banknotes/deposit.

As the discount grew, retailers would quote different prices for cash or cheque/card settlement. And as to the note switch-over costs, the “experiment” of Europe’s economic and monetary union demonstrates the feasibility.

The looming conversion would provide an essential degree of freedom for monetary policy. In terms of our illustrative arithmetic, the risk-free interest rate could fall to a negative 3.33 per cent a year without triggering cash withdrawals from the banking system."

As time goes on, the bond becomes worth less, making it a less desirable product.

"Is the exercise worth it?

The main reason for believing it is stems from an appreciation of how the bursting of a global credit bubble influences the equilibrium level of risk-free interest rates relative to risky rates of return and in absolute terms.

Most of us would agree that the bursting process ushers in a period during which soberly-measured risk premiums increase sharply.

This means that the risk-free rate must plunge to be consistent with an average overall cost of capital which reflects the new glut of savings.

So, in terms of our illustrative arithmetic, it is plausible that the neutral risk-free nominal rate of interest in the US and Europe, especially taking account of a likely near-term drop of the price level, is significantly negative.

The central bank and government, by devising a system in which such negativity can express itself, can give a big fillip to the recovery process.

The most direct channel for this fillip most likely passes through the equity market.

Pervasive negative risk-free rates across the advanced economies would underpin equity market levels.

Investors faced with certain substantial nominal loss on risk-free holdings would bid up the price of equity which could offer rich risk premiums even at a presently feebly level of prospective earnings.

And it is equity market developments which hold the key to the economic recovery."

As these looming losses approach, investors will shift from the bonds to stocks, spurring investment and new business and job growth, and I suppose there will be a kind of wealth effect as well.

"As consumers across the globe retrench, the forces of equilibrium should (if not thwarted by zero rate traps) bring about a redistribution of economic output, away from the production of consumer goods and towards capital goods (including technological know-how).

A higher rate of business investment matched by lower consumption now will have a counterpart in higher-than-otherwise consumption in the far-off future.

A resilient equity market with its counterpart in a low cost of equity capital is the key motor behind that transformation.

Firms across much of the global economy would respond to the combination of squeezed profit margins, low equity capital costs and continuing technological progress by “capital deepening” (increasing the ratio of capital to labour).

That would mean a challenging increase in frictional unemployment and pressure for increased social insurance of the losers.

Losses and losers are an inevitable consequence of the big credit bubble which is bursting. In the equity markets these losses reflect swathes of now obsolescent capital stock in the wrong place at the wrong time.

The key to rapid progress towards re-building wealth is to nurture the golden egg of the equity market, in which the coming capital spending upturn will be financed and to minimize monetary disequilibrium in the meantime.

The scheme proposed here for sharply negative interest rates promises much on both objectives."

So, basically, if investors do shift from bonds to stocks ( Or buy corporate bonds, I suppose )

1) Businesses will borrow ( Spending on capital goods, building things )

2) Creating jobs

3) People will spend more

4) The economy will grow

What's with the Golden Egg? It's been used now by McTeer, Becker, and Brown.

Will this work? I have to admit to liking it, because it involves using incentives to refocus the look of risk to the investor. And I believe that combating fear and aversion to risk is the main problem facing us.