This post is partly in response to a long conversation I’ve been having with Rodney Everson. He appears to be the first person to mention the negative interest rate on reserves idea, but I am less enthused about his argument that raising the fed funds target above zero can actually be expansionary:
Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.” If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph. You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.
It is true that a zero fed funds rate promotes massive hoarding of base money, and also that base money hoarding is, ceteris paribus, highly contractionary. But the Fed cannot solve this problem by raising the fed funds target. Markets would interpret that action as being contractionary, as a signal that the Fed plans to withdraw funds to make the new target stick.
How can we reconcile the following two facts:
1. Near-zero short term rates are almost always associated with disinflation and low output, not a booming economy.
2. In the short run, a cut in the fed funds rate target is an expansionary action.
The answer is that (as Milton Friedman said in 1997) near-zero rates are a sign that money has been tight.
So how do we solve this problem? Some Keynesians argue that we need to promise to hold rates near zero for an extended period. But that’s not really a satisfactory answer. The Japanese case shows that an extended period of near-zero rates may accomplish nothing; rather it may simply reflect a period of continual NGDP stagnation.
Instead, the Fed needs to raise inflation using a different policy tool, some tool other than the fed funds target. This might involve QE, or it might involve cutting the IOR, perhaps to negative levels. Or it might involve a target rate for the trade-weighted exchange rate. But the best option is to use level targeting as a policy tool. Set a much higher price level or NGDP target trajectory than the market currently expects, and then promise to make up for any future shortfalls.
Higher rates are associated with prosperity. But we can’t get to prosperity by having the Fed raise rates. The Fed must use other steps to raise NGDP growth expectations so high that the Fed will need to raise the fed funds target in order to prevent the economy from overshooting its target. We need to whip the horse so hard that we need to pull back on the reins to keep it from running too fast. But pulling back on the reins, by itself, will simply slow the horse down.
We don’t need higher short term rates right now, we need to do other things that will result in the Fed needing to raise short term rates in the future. And the sooner the Fed needs to raise short term rates the better. Promising to hold rates near zero for an extended period is not that answer, as the Japanese have learned over the past 15 years.
PS. Would my grammar teacher have approved of the phrase “need to need?”
PPS. I’m actually not that far from Everson, if the Fed did the right thing with its other policy tools then it would soon be able to raise the fed funds target a bit above zero.
Tags: Milton Friedman