San Francisco Fed Makes Case for Negative Interest Rates, Says It Would Have Helped in Recession

Chris Gaetano
Published Date:
Feb 5, 2019

The San Francisco Federal Reserve Bank, in a recent paper, suggested that lowering interest rates into the negative could have reduced the pain of the 2007-2009 recession and allowed for a faster recovery. During the height of the crisis, the Federal Reserve, like many central banks around the world, lowered interest rates to near zero in order to stimulate the economy. Several, such as the Bank of Japan, actually allowed rates to dip into the negative, which means that savers will actually pay interest rather than receive it, and so if they don't spend their money it will slowly evaporate. While savers could theoretically just withdraw their money and hold it as cash, the San Francisco Fed said that, in practice, most would likely recognize that even if interest rates go negative that's still better than walking around with giant stacks of bills that could be physically taken from them. 

Using computer models, the Fed paper says that a negative interest rate would have been beneficial in the United States.

"Model estimates suggest that reducing the effective lower bound for the federal funds rate to –0.75% would have reduced economic slack by as much as one-half at the trough of the recession and sped up the ensuing recovery," said the paper. "While the boost to the economy would have been negligible after 2014, inflation would have been higher throughout the recovery by about half a percentage point on average." 

One possible critic of such an idea would be the former governor of the Bank of England, Mervyn King, who, in an interview with The Trusted Professional, was very critical of negative interest rates, saying that they might address problems in the short term but that they do so by essentially mortgaging the long-term economic future. 

"Cutting interest rates can buy time—what it does is try to encourage people to spend today rather than tomorrow," King said. "That works a bit, and you see these spending figures and economic data improving. But then it peters out. Why? When you transfer spending from the future to the present, you dig a hole—time passes, and the future becomes today. So, now you cut interest rates again to bring even more spending forward, and that digs an even deeper hole. As time passes, that too becomes the present, and if you haven’t tackled the underlying problem, you create more and more of an incentive for central banks to cut rates further.

"But there’s a limit to how much people want to bring spending forward from the future to the present. You have to do more and more monetary policy measures to maintain current levels of spending, and at the cost of reducing spending in the future. … So, it may buy time, but that time runs out. Monetary policy exhibits diminishing returns the longer you do it, if you don’t take action to deal with the underlying problems. And that is the mistake being made now. There is an assumption by many policy makers that there aren’t underlying problems and the cause of the weakness in demand is only temporary—some kind of headwind that will abate over time. And if we just wait long enough, the problem will go away. I don’t think that’s true. Until this problem is tackled, monetary policy has reached the limit of what it can do."

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