The Bank of Japan’s recent decision to join the ranks of central banks adopting negative policy rates caused a huge stir in financial markets, for two reasons. One, it pushed the US further out of sync with the central banks of the two other developed economic blocs. Two, the market reaction made it clear that the psychological boost markets used to feel from exceptional monetary action is all but dead.
This left markets with two unsettling—if slightly contradictory—thoughts. On the one hand, markets quickly started speculating as to whether the Federal Reserve would also resort to negative policy rates if conditions deteriorated sharply. And, on the other, it signaled to many that the safety net of the central bank backstop has finally been pulled out of under us. No more Fed put. No more Bernanke blanky.
I see three simple reasons Fed shouldn’t react to a sharp downturn with
We have all witnessed the diminishing marginal effects from exceptional monetary policy. As I’ve long argued, if we understood monetary policy better it would work less well. Guess what? We’re starting to understand it. People need to want to take risk if the economy is to grow, and the price of money is a much smaller factor in these decisions than traditional economic theory leads us to believe. Monetary policy liquidity can short circuit financial runs, buy time to fix balance sheets, and encourage financial risk taking. But it can’t force the economy to drink. Negative rates aren’t likely to change this.
The US is not Uganda (#GIK). Confidence is at the heart of the global credit-based system, and the US dollar is the system’s lynchpin. Whether you like it or not, whether you think its role is waxing or waning, the USD is like no other currency in the world. I am usually a big fan of looking around the world to see what we can learn from other countries’ experiences, but I’m afraid in this case there are no clean comps.
And the shock to confidence from negative policy rates in the US could be strongly adverse. Money illusion is real. When you say negative rates, Americans hear confiscation. USD holders around the world might too. This—real or imagined—undermines confidence. In a multi-equilibrium world, it is confidence that most often determines which equilibrium you land on. The downside is large.
USD plumbing is different. It is not clear how well the architecture of dollar-based finance would hold up under negative rates. Money markets and other short-term funding markets would come under serious stress. Systems may or may not be able to handle it. We—or at least I—just don’t know. But we do know the scope for unintended consequences is meaningful.
The bottom line is if the marginal benefits have demonstrably decreased, and the risk—however small you think the probability may be—is the potentially huge downside of undermining confidence in the
central feature of the global financial system, expected value tells you not to take that risk. To paraphrase Vizzini, “Never go in against confidence when death is on the line”.