I did an email interview with Cezmi Despinar about the Swiss move to negative interest rates. Cezmi posed great questions.
Cezmi: Is the SNB now engaging in a “beggar thy neighbor” policy with the Fed, the ECB and the BoE by introducing a negative interest rate? Some people even talk about “currency wars”.
Miles: No. It is only a “currency war” if it involves a policy that would cancel out if every country did it. But if every country introduced negative interest rates, it wouldn’t cancel out, it would be a worldwide shift toward monetary stimulus. Actually, at the zero lower bound, and assuming it focused mostly on short-term government bills, the Swiss National Bank’s already existing policy of purchasing foreign assets to keep the Swiss franc from appreciating was a policy that would cancel out if all countries did it. So the shift toward negative interest rates, which will then require less purchasing of foreign assets, is a shift away from currency war on the Swiss National Bank’s part.
Cezmi: Have the SNB’s policy tools been reduced significantly? What else can the SNB do to prevent an excessive appreciation of the Swiss franc or to make it less attractive to hold Swiss franc investments? Helicopter money?
Miles: As I explain in my column “The Swiss are now at a negative interest rate due to the Russian ruble collapse,” negative interest rates are a very powerful policy when not only the interest on money kept at the central bank and the target rate, but also the paper currency interest rate is reduced:
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.
The Swiss National Bank knows how to do this. So it has all of the policy tools it needs. The key extra tool in its back pocket is the possibility of using a time-varying paper currency deposit fee to create a negative interest rate on paper currency.
Cezmi: Switzerland’s monetary base has almost increased by eightfold, but the overall inflation is negative for many months in a row. Which macroeconomic lessons are we supposed to draw from the current unconventional action of the SNB?
Miles: NYU Professor John Leahy framed it this way when he visited the University of Michigan this Fall: when interest rates on short-term government bills are almost the same as the interest rate on paper currency, the monetary base becomes a misleading measure of monetary policy because some of the monetary base is being used for saving (like short-term government bills at a similar interest rate) rather than transactions. For the size of the monetary base to mean what people are used to, the monetary base has to earn a lower interest rate than short-term government bills, so that the monetary is once again primarily devoted to supporting transactions.
If the interest rate on the monetary base–including paper currency–were 100 basis points (1%) below the interest rate on short-term government bills, a much smaller monetary basis could be very stimulative. But with interest rates on the monetary basis essentially the same as interest rates on short-term government bills, some of the “monetary base” is not being used as monetary base, but as an equivalent for short-term government bills.
The bottom line is that at low interest rates, the paper currency interest rate is important enough that cutting other interest rates and increasing the monetary base doesn’t do that much (though it has somestimulative effect). So it is crucial to make the paper currency interest rate a tool of policy rather than keeping it always at zero, as has been the tradition.
With Donna D'Souza, I wrote a children’s story to explain how money being used simply for saving rather than transactions doesn’t stimulate the economy, and how negative interest rates can help: “Gather ‘round Children, Here’s How to Heal a Wounded Economy.” And my column “Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere? explains the famous Quantity Equation MV=PY, which says that it isn’t the amount of money M alone that matters for monetary policy, but money’s velocity V as well. When the interest rate on short-term government bills gets too close to the paper currency interest rate, velocity goes way down. The way to restore velocity is to cut the paper currency interest rate.