Francis Coppola on negative interest rates

Tyler Cowen linked to a post by Frances Coppola:

But one thing seems clear. How negative rates would work in practice is no clearer than how QE works in practice. They are experimental, and their effects are complex. Hydraulic monetarist arguments (“if you can get rates low enough the economy will rebound”) are simplistic.

Monetarist?  Don’t they focus on the money supply and/or NGDP expectations?  Most people would consider Milton Friedman a monetarist, and here’s what he had to say about low rates:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.   .   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

In a monetarist model, lower market interest rates are contractionary for any given monetary base, because they reduce velocity.  It’s the Keynesians who are likely to claim that lower rates are expansionary.  Now of course Friedman was talking about market interest rates, not IOR. Lower IOR is theoretically expansionary, and so far markets have reacted to negative IOR announcements as if they are expansionary.

Will that be true in the future?  Nothing is certain, as monetary policy is very complex, and concrete action A can always be interpreted as a signal of future concrete action B.  Anything is possible.  A $1 billion increase in the base can have a contractionary impact if a $2 billion increase was expected.  But any monetary analysis should start from the presumption that reducing the demand for an asset will reduce its value.  A reduction in the value of base money is expansionary.  That means lower IOR has a direct expansionary impact on NGDP.  (Secondary effects are complex, as Coppola suggests.)

Indeed, individual banks can avoid paying negative rates on excess reserves. They can discourage customers from making deposits; they can choose to hold reserves in the form of physical cash; or they can increase new lending (not refinancing), since the balance sheet result of new lending is replacement of reserves with loan assets.*

But of course the reserves do not disappear from the system. They simply move to another bank, which then incurs the tax. The banking system AS A WHOLE cannot avoid negative rates on reserves. The reserves are in the system, so someone has to pay the negative rate. If banks increase lending to avoid the negative rate, the velocity of reserves increases. It’s rather like a game of pass-the-parcel.

This is a common misconception, which I see all the time.  If individual banks don’t want to hold a lot of excess reserves, they can simply buy other assets with them.  If the banking system as a whole wants to reduce its holding of excess reserves, it can reduce the attractiveness of deposits until the excess reserves flow out into currency held by the public.  The central bank controls the monetary base, not bank reserves. The composition of the base is determined by banks and the public.

It seems reasonable to suppose that negative interest rates might increase loan demand. Negative interest rates on reserves put downwards pressure on benchmark rates and thus on bank lending rates, attracting those who would otherwise be priced out of borrowing. But typically those are riskier borrowers. We have just spent eight years forcing banks to reduce their balance sheet risk. Do we really want to force banks to lend to riskier borrowers? Of course, tight underwriting standards could be used to deny those people or businesses loans: but doesn’t that rather defeat the purpose of negative rates? It’s something of a double bind.

We need an easier money policy and, if banks are taking excessive risks, a tighter credit policy.  It’s best not to mix up monetary and credit issues.  Negative IOR is about reducing the demand for base money, which is inflationary; it’s not about increasing bank loans.  Central banks should not be trying to encourage more debt creation—unless you want to end up like China (where the policies are unfortunately linked together.)

In the end I agree with those who are skeptical of negative interest rates.  These ultra-low interest rates are a sign that monetary policy is too contractionary. The developed world needs much higher interest rates, but only if we get there with an expansionary monetary policy.  In December the Fed tried a short cut, raising rates without boosting NGDP growth. This is putting the cart before the horse.  You need to generate higher NGDP growth expectations first, and then you can achieve a permanently higher level of interest rates.


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33 Responses to “Francis Coppola on negative interest rates”

  1. Gravatar of jknarr jknarr
    17. February 2016 at 14:57

    Scott, I’m really skeptical of negative interest rates in the US in particular; esp their legality.

    How a public institution can reach into a private bank to (involuntarily) extract capital is a bit baffling.

    Would shareholders put up with it? Wasn’t this sort of thing addressed in the 5th amendment, i.e. the “takings clause”? Is this even a public institution taking private property for public use? Maybe the Fed is private in this capacity. If so, would negative rates lead to banks exiting the Federal Reserve System?

    Are negative rates an involuntary tax (direct or apportioned?) or is it a fee for services (commerce?) or a penalty (again contractual?) Are negative rates taxed as losses? On a capital gains or income basis?

    Negative rates might work elsewhere, but the US system is pretty unique. None of these legal issues seem clear. I just know that if I was a bank shareholder watching my capital walk out the door, I’d be tempted to have a class action to sort the issue out.

  2. Gravatar of ssumner ssumner
    17. February 2016 at 15:04

    jknarr, If we had a better monetary policy we wouldn’t even need to consider these options.

    But look, the government can seize cash from you while driving down the road for no reason at all, even if you have committed no crime. In this kind of country do you really think they can’t do negative IOR? That horse left the barn long ago, it’s too late to worry about legal niceties. The Constitution is gone.

  3. Gravatar of jknarr jknarr
    17. February 2016 at 15:58

    Scott, your cynicism is showing! I like it.

    Negative rates necessitate eliminating cash as well. So OK, just imagine what “takings” will occur in a cashless society, if what you say is true.

    It’s going to be very chilling for society when you can become an economic non-entity at the stroke of a bureaucrat’s keyboard. Try hiring a lawyer, or even feeding yourself, if you fall under suspicion.

    Well, if the constitution is gone, then that only leaves the states as sovereign entities. At least we got that going for us.

  4. Gravatar of Dennis Dennis
    17. February 2016 at 16:28

    There is nothing involuntary about it, banks choose freely to maintain excess reserves at the Fed and if they don’t want to pay they can withdraw them.

  5. Gravatar of Kevin Erdmann Kevin Erdmann
    17. February 2016 at 16:34

    “Do we really want to force banks to lend to riskier borrowers?”

    Yes! Yes, we do! Is this a serious question?

    This is like, in finance, where you’ll see financial planners say that now they are recommending to overweight in “high quality” stocks. Oddly, financial planners never recommend “low quality”. Surely, if stocks can be arranged on a quality scale, you would over-weight low quality just as often as you would over-weight high quality, unless they are just spouting banalities.

    Likewise, in public discourse, no respectable person would recommend that banks should engage in riskier lending. The fact that in today’s context people can suggest that banks shouldn’t be taking more risks without being laughed at is one large reason we are stuck in 2nd gear.

  6. Gravatar of Kevin Erdmann Kevin Erdmann
    17. February 2016 at 16:38

    Actually, we shouldn’t force them to lend to riskier borrowers. But, it would help if we weren’t institutionalizing threats about liabilities we will force on them if they make loans that end up going bad because of unforecasted real shocks, which we will blame on them, because everyone knows that bankers are always too risky.

    Or, better yet, get rid of the 1,000 laws that favor debt over equity ownership so that the banks are less important. If risky borrowing is so bad, maybe we shouldn’t force people to borrow with tax code incentives.

  7. Gravatar of E. Harding E. Harding
    17. February 2016 at 16:49

    Good post. I’m not sure why Tyler would expect us to believe that Coppola’s remarks would convince anyone about anything regarding the effectiveness or lack thereof of negative rates, but, then again, I’m not Tyler. Negative IOR probably hurts banks, increases base velocity, and encourages cash hoarding. Negative rates are not a particularly powerful tool precisely because they decrease the opportunity cost of holding cash.

  8. Gravatar of ssumner ssumner
    17. February 2016 at 16:58

    E. Harding, You said:

    “Negative IOR probably hurts banks, increases base velocity, and encourages cash hoarding. Negative rates are not a particularly powerful tool precisely because they decrease the opportunity cost of holding cash.”

    That sounds about right to me.

  9. Gravatar of Benjamin Cole Benjamin Cole
    17. February 2016 at 17:11

    “In the end I agree with those who are skeptical of negative interest rates.  These ultra-low interest rates are a sign that monetary policy is too contractionary. The developed world needs much higher interest rates, but only if we get there with an expansionary monetary policy.  In December the Fed tried a short cut, raising rates without boosting NGDP growth. This is putting the cart before the horse.” — Scott Sumner

    Right. But I do not hear the Market Monetarist community forthrightly calling for very large and aggressive QE.

    I think there still is an amount of obscurantism, or fear of being labeled a Zimbabwe money-printer, in the macroeconomics community.

    Michael Woodford calls for QE in combination and to finance fiscal stimulus, which I prefer to be tax cuts.

    Why all this timorousness about printing money?

    Scott Sumner: you say negative interest rates are probably not enough. Okay, put it out on the table. How much QE a month? $100 billion?

    Interesting question: they say Bernie Sanders economic plans won’t work. But what if he financed his expansion of federal spending through QE?

    BTW the US economy grew by 8.5% real in 1965.

  10. Gravatar of jknarr jknarr
    17. February 2016 at 17:37

    Dennis, reserves operate in a closed system. Read the Coppola piece again, she has a subtle grasp on the fixed nature of reserves. The level of reserves in the system is fixed by the federal reserve. Private banks must carry all the reserves on their books; there is nowhere else for reserves to go. The Fed pays interest on both required and excess reserves, and would extract capital from private banks proportionally under negative rates.

    If the Fed wants to hand seigniorage receipts to banks (instead of taxpayers), that’s their business – from the banks perspective, it’s free money. If the fed wants to extract private capital and hand it over to the Treasury, that’s, well, expropriation.

  11. Gravatar of Joe Joe
    17. February 2016 at 17:54

    Benjamin, I think the secret is how Bernanke did in QE3 – we will do X amount of QE until we see Y growth in a certain variable. Even if the Fed said Y was 2% inflation, it would be much more expansionary than now. And all that QE probably wouldn’t even be necessary if the Fed would prove they were serious.

    But if the Fed keeps tightening now, they’ll have to do something far more ‘reckless’ in the future.

  12. Gravatar of Bob Travels Bob Travels
    17. February 2016 at 18:18

    It seems that the main reason for negative rates has gone astray in this discussion.

    All the central banks with negative interest rates are attempting to reduce the exchange rate of their currencies.

  13. Gravatar of Major.Freedom Major.Freedom
    17. February 2016 at 18:20

    “In a monetarist model, lower market interest rates are contractionary for any given monetary base, because they reduce velocity.”

    This fallacy again?

    No, interest rates have nothing to do with velocity. Higher interest rates does not mean higher aggregate spending. Higher interest rates could be the result of a trade off between consumer spending and investment spending. Rates can rise without any additional increase in spending as such.

    Your first statement of this fallacy included rates controlled by the Fed. Now you’re saying market rates, but that doesn’t change anything.

    At any rate you cannot isolate interest rates from the base, because the base itself, or rather the change in the base, influences interest rates.

  14. Gravatar of E. Harding E. Harding
    17. February 2016 at 18:30

    “BTW the US economy grew by 8.5% real in 1965.”

    -No, it didn’t.

  15. Gravatar of JLK JLK
    18. February 2016 at 00:21

    Two points to offer:
    (1) A friend who is well-placed in the guts and plumbing of the banking industry tells me negative IOR would be difficult, practically speaking. The systems just aren’t wired that way! Would “interest” become “vendor payment”? How many spreadsheets would that break? How many SQL queries? Worse than the Y2K problem, which had a small army of consultants marching toward a well-defined battle line. If the Fed should declare March to be the “Inside Out Backwards On Your Head Month,” it would create a technical stew leading to FUD right when the Fed would presumably be seeking clarity, new resolve, and a regime capable of achieving the “better” of multiple equilibria. So maybe that arrow is crooked; what else is in the quiver at this late date — 9 (!) years after NGDP tightening?
    (2) The US and Europe are bearing an uncanny resemblance to Reinhart and Rogoff. Sure, that was a reduced-form correlation-not-causation (and not even that, as we learned from the UMass Econ department). But the fact is that (pro-podean) monetary policy decision makers have made errors and been just as reluctant to admit them and embrace a helpful stance as Keynesian legislators in our textbooks. One can’t unfoul the bed; but does Scott or any other posters have insights from the market monetarist theory of error placed solely on monetary blunders that could make a difference now? I believe Scott has adopted 3-3.5% NGDP growth as a new fact of life/policy decision. Can that be made commensurate with economic well-being and broadly shared happiness? I don’t think an NGDP futures market starting in 2018 or after can quite clean the sheets.

  16. Gravatar of Benjamin Cole Benjamin Cole
    18. February 2016 at 04:59

    Joe:

    I agree with QE3, perhaps even married to FICA tax cuts.

    My complaint is that the Market Monetarism community is not forthrightly presenting an alternative.

    MM’s leading lights do not title posts, “$100 Billion A Month of QE, And It Rises From There Until We See NGDPLT At 6.5%”

    Some of this is academic obscurantism, and disdain for simply writing “print (digitize) more money.”

    I think some of the reticence to be blunt is fear of taboos, of being accused of monetizing debt and printing tax receipts (even though that is what needs to be done). It is hard to believe that in 1992 Milton Friedman bashed the Fed for being too tight when inflation was at 3%, and the Fed had cuts the funds rate from 10% to 3%. Today there is abject fear of being labelled soft on inflation.

    But this timidity aids and abets the idea we will all die at 3% inflation, or if the US in fact monetizes debt for a while, and prints money as tax receipts.

    Michael Woodford has also raised reasonable concerns that many people will not believe or understand forward guidance by the Fed. Jawboning will only go so far. I don’t believe the Fed anymore, btw.

    Try printing up FICA tax receipts for a few years. The public will believe that. And spend the extra cash.

    There, I said it out loud.

    Print more money and cut taxes.

  17. Gravatar of Tim Tim
    18. February 2016 at 07:16

    Scott,

    Are you arguing that negative ior is not necessarily easier monetary policy? I know you mentioned that you think tighter rates can often be correlated to tighter monetary policy.

    Thanks, Tim

  18. Gravatar of ssumner ssumner
    18. February 2016 at 07:21

    Ben, Europe and Japan could clearly use lots of QE. The US could first try cutting rates to zero.

    knarr, That’s completely wrong, as I’ve pointed out numerous times. The Fed controls the base, not reserves. Commercial banks control the level of reserves.

    Bob, They expect currency depreciation, but they are actually trying to boost inflation and NGDP.

    JLK, Just to be clear, I am not recommending negative rates, I am recommending NGDPLT. My point is that markets react to negative IOR as if it’s expansionary. I agree that it causes problems for the banking system.

    I am not sure what you are asking in point 2.

  19. Gravatar of Ray Lopez Ray Lopez
    18. February 2016 at 07:39

    I just cut and pasted this into my Sumner file. The absurdity and untestable nature of it leaves one breathless.

    Sumner metaphysics: https://www.themoneyillusion.com/?p=31490

    “In a monetarist model, lower market interest rates are contractionary for any given monetary base, because they reduce velocity. It’s the Keynesians who are likely to claim that lower rates are expansionary. Now of course Friedman was talking about market interest rates, not IOR. Lower IOR is theoretically expansionary, and so far markets have reacted to negative IOR announcements as if they are expansionary.

    Will that be true in the future? Nothing is certain, as monetary policy is very complex, and concrete action A can always be interpreted as a signal of future concrete action B. Anything is possible. A $1 billion increase in the base can have a contractionary impact if a $2 billion increase was expected. But any monetary analysis should start from the presumption that reducing the demand for an asset will reduce its value. A reduction in the value of base money is expansionary. That means lower IOR has a direct expansionary impact on NGDP. (Secondary effects are complex, as Coppola suggests.)”

    Sumner’s “open mouth” operations metaphysics leave one aghast, with open mouth.

  20. Gravatar of Anthony McNease Anthony McNease
    18. February 2016 at 07:51

    “The banking system AS A WHOLE cannot avoid negative rates on reserves. The reserves are in the system, so someone has to pay the negative rate. If banks increase lending to avoid the negative rate, the velocity of reserves increases. It’s rather like a game of pass-the-parcel.”

    Isn’t he just describing the hot potato effect? That sounds a lot like “this will just increase velocity” implying that increased velocity doesn’t do anything. That sounds awfully wrong.

  21. Gravatar of JLK JLK
    18. February 2016 at 07:57

    Thanks for replying Scott (as you laudably do to most of your comments). I guess my 2d point is just “you can’t push on a string” dressed up. Are there reasons besides failure of imagination why we can’t seem to shift regimes/outcomes? Because after 9 years, maybe there is more to it than “monetary policy is wrong.”

  22. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    18. February 2016 at 08:05

    People don’t stop “reasoning from a price change”

    “Negative interest rates on reserves put downwards pressure on benchmark rates and thus on bank lending rates, attracting those who would otherwise be priced out of borrowing”

    No, if rates are lower and there is no increase in volume it is because demand has been low and probably will remain so if nothing changes …

  23. Gravatar of Dan W. Dan W.
    18. February 2016 at 08:23

    Can NGDP be increased without the central bank lowering interest rates?

    If YES then let’s do it.
    If NO then there are complications, as discussed in this post and in the comments.

  24. Gravatar of ssumner ssumner
    18. February 2016 at 09:50

    Ray, You need some smelling salts, before you faint.

    Anthony, That quote is wrong, as the system as a whole can get rid of reserves. The HPE applies to base money, not reserves.

    JLK, You said:

    “Are there reasons besides failure of imagination why we can’t seem to shift regimes/outcomes? Because after 9 years, maybe there is more to it than “monetary policy is wrong.””

    That argument is easy to address. In 1975 we were 9 years into the Great Inflation, and it was simply a failure of monetary policy. We’ll figure it out eventually, we always do.

    We no longer have deep deflations and we no longer have high inflation. Monetary policy is getting better, one step at a time. See my newest post on Bullard. It just takes time.

    Jose, Good find.

  25. Gravatar of Frances Coppola (@Frances_Coppola) Frances Coppola (@Frances_Coppola)
    18. February 2016 at 10:06

    Scott,

    I think you and I are roughly on the same page.

    The “hydraulic monetarists” I refer to are those who are in favor of abolishing physical cash and using deeply negative rates to “shock” the economy out of its stagnation. I regard this as a very dangerous course of action, since it would create complete dependence on automated payment mechanisms and reverse the normal process of credit intermediation. The effects of this are completely unknown.

    As you say, banks do not have to hold excess reserves: they could simply make deposits unattractive, encouraging depositors to convert them to physical cash. The question in my mind is why banks are so reluctant to discourage deposits. Danish and Swedish banks, for example, are openly saying that they will not pass the negative rate on to depositors. Some banks are discouraging or even refusing to accept large deposits: RBS for example refused to accept a very large placement of client money from Hargreaves Lansdowne, to the annoyance of the latter’s CEO (I was there when he and Ross McEwan had a public argument about this).And HSBC recently announced that it might impose negative interest rates on Euro deposit accounts held by UK businesses if the ECB cuts the MRO rate into negative territory. But that’s as far as it goes at the moment. I suspect that the problem is public perception of the purpose of banks and the likelihood of a very negative political reaction.

    Anthony McNease,

    Yes, it’s the hot potato effect. Negative rates tend to increase the velocity of reserves. If you look through the comments on the post you will see that Nick Rowe has made this point too. In my 2012 post about negative rates (linked under “Related Reading”) I actually used the term “hot potato”, and added that I could see this leading to all manner of stupid investments. Increasing the velocity of reserves would not necessarily mean an increase in productive lending. In fact it might not mean an increase in new lending at all. There are still plenty of securities out there for banks to purchase.

    Jose Romeu Rabazzi

    Negative policy rates do put downwards pressure on short-term benchmark and market rates. Whether that results in more lending is, I agree, a question of underlying demand. It is not me who is reasoning from a price change, but the policymakers who assume that cutting interest rates means more lending – or, for that matter, that raising them means less lending. Neither is necessarily true.

  26. Gravatar of ssumner ssumner
    18. February 2016 at 12:16

    Frances, Like you, I am strongly opposed to abolishing cash, in my case partly for libertarian reasons. But the risks you mention are clearly something to think about.

    I’m also a bit puzzled by the zero lower bound on deposit rates. It’s hard to predict if that would eventually break down, if negative IOR was permanent. In any case, I think we probably both agree that a better solution is fast enough NGDP growth so that equilibrium nominal rates rise above zero.

    I don’t want negative IOR to become “we can live indefinitely with negative rates.”

  27. Gravatar of Matt McOsker Matt McOsker
    18. February 2016 at 12:35

    Miles Kimball has been arguing that for negative rates to work, then it needs to be fierce:

    “There is a world of difference between a central bank that cuts some of its interest rates, but keeps its paper currency interest rate at zero and a central bank that cuts all of its interest rates, including the paper currency interest rate. If a central bank cuts all of its interest rates, including that paper rate, negative interest rates are a much fiercer animal.”

    http://blog.supplysideliberal.com/post/139340010517/if-a-central-bank-cuts-all-of-its-interest-rates

    Either way, his blog has lots of good food for thought.

  28. Gravatar of Joe Joe
    18. February 2016 at 16:08

    Benjamin, I see your point. The ideal world of 1) set up NGDP futures market and 2) target 5% is great, but maybe too creative and complex for a government agency. I’d settle for just signalling for 2% inflation, lowering to 0% and saying we will not raise rates until we see 2%. If inflation drops, we will do $100 billion per month in QE until we get there.

  29. Gravatar of ssumner ssumner
    18. February 2016 at 19:47

    Matt, I’d prefer NGDPLT, or even QE, to negative rates.

  30. Gravatar of Maurizio Maurizio
    19. February 2016 at 08:12

    We need an easier money policy and, if banks are taking excessive risks, a tighter credit policy. … Negative IOR … is not about increasing bank loans.

    Excuse me, how can banks decrease their excess reserves without increasing their loans? Thanks

  31. Gravatar of Frances Coppola Frances Coppola
    19. February 2016 at 13:05

    Matt,

    What Scott said.

    I’m familiar with Miles’s work. Indeed I have had long arguments with him about this. I remain highly sceptical of deeply negative rates as a policy tool, and I’m very concerned about the social consequences of abolishing physical cash.

    Maurizio,

    By converting them to physical cash, either by increasing vaulted holdings themselves or by discouraging deposits.

  32. Gravatar of Scott Sumner Scott Sumner
    19. February 2016 at 19:05

    Maurizio, They can buy bonds.

  33. Gravatar of Maurizio Maurizio
    20. February 2016 at 04:40

    Maurizio, They can buy bonds.

    Thank you prof. In my ignorance, I thought that to buy bonds is to lend money. So your answer still leaves me a bit puzzled.

    By converting them to physical cash, either by increasing vaulted holdings themselves or by discouraging deposits.

    Thank you prof. Coppola. I did not realize banks could avoid paying interests by just holding the money themselves.

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