Negative interest rates are in the news in a way I have never seen before. I have been pleased to hear (from two different sources) that when clients ask one well-known bank what to think about negative interest rates, they are referred to my IMF Working Paper with Ruchir Agarwal “Breaking Through the Zero Lower Bound” as the best source for understanding the issues.
Yesterday, Janet Yellen was asked about negative interest rates in her Congressional testimony. This has generated a plethora of news articles. Above, I display screenshots and links to two relevant Wall Street Journal articles. Both are excellent. In this post, I will only try to discuss “Four Legal Questions the Fed Would Face If it Decided to Go Negative,”by Joshua Zumbrun, leaving a discussion of “Fed Nods to Negative Rates, Hurdles and All” by Michael S. Derby and Joshua Zumbrun to a later post.
First, let me copy here the quotations in “Four Legal Questions the Fed Would Face If it Decided to Go Negative,” that come from my interview with Joshua on Monday, February 8 (before Janet Yellen’s testimony) about whether the Fed could impose negative interest rate on reserves:
“This is too important for the legal issues to be argued only in an opaque way within the Federal Reserve system,” said Miles Kimball, an economist at the University of Michigan who has advocated for negative rates. …
Can You “Pay” a Negative Amount?
The 2006 law that authorized the Fed to pay interest directly to banks never contemplated negative rates. The precise wording says depository institutions “may receive earnings to be paid by the Federal Reserve.” A negative interest rate, however, would have the Fed collecting a levy from deposits, rather than paying interest on them.
One thing working in the Fed’s favor is the broad language in the Federal Reserve Act that says the Fed shall pursue full employment and price stability.
“The Fed can always argue in court that they would be violating the law by not getting to full employment and price stability if we didn’t have negative interest on reserves,” Mr. Kimball said.
The so-called dual mandate in the Federal Reserve Act is generally seen as granting the Fed broad authority to do what it sees necessary to obtain those goals. In central banking, this is known as “instrument independence.” Congress sets the goals, but the Fed is free to determine where to put rates in order to meet the goals.
The first quotation came from my urging Joshua to emphasize the importance of legal scholars arguing all sides of the question of what the limits to the Fed’s authority are in this area. I would say even more broadly that more law review articles should be written about the Fed’s monetary policy authority. In addition, I stand ready to host guest posts by any lawyer who wants to seriously tackles these issues in print.
The second quotation retails some of what I learned from guest posts on this blog by Greg Shill. My bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” has an all too small section on legal issues that includes Greg’s two guest posts. Here are that section on legal issues, copied in full:
- Legal Issues Relevant for the Transition to Electronic Money
- Greg Shill: So What Are the Federal Reserve’s Legal Constraints, Anyway?
- Greg Shill: Does the Fed Have the Legal Authority to Buy Equities?
- However Low Interest Rates Go, The IRS Will Never Act Like a Bank
- US Law for the Tussle Between Different Modes of Payment
In addition to interviewing me, Joshua Zumbrun interviewed Peter Conti-Brown, a lawyer and financial historian at Wharton. Peter Conti-Brown argues that the Fed has the authority to charge fees. That would allow negative interest on reserves.
But there may be another way to keep a zero interest rate on reserves from creating a zero lower bound on interest rates. What if the Fed had a zero interest rate on reserves, but limited the amount that banks could hold in their reserve accounts to no more that 101% of required reserves? Could the Fed do that legally? If so, the inability of banks to get a zero interest rate on an unlimited quantity of reserves would keep the zero interest rate on reserves from creating a zero lower bound. For example, if the Fed bid up the prices of 3-month Treasury bills through ordinary open market operations above the face value, Treasury bill rates would be negative. That would make banks want to put funds into reserves instead of Treasury bills, but they couldn’t beyond a certain point. They could try to increase the amount of reserves they were required to hold. But the Fed has clear authority over the amount of reserves that are required, so that does not open the door to unlimited funds in reserves.
This all goes back to a principle my brother Chris and I address in “However Low Interest Rates Go, The IRS Will Never Act Like a Bank”: a zero interest rate that only applies to a limited quantity of funds does not create a zero lower bound. The reason that our current paper currency policy creates a zero lower bound is that under current policy banks can withdraw an unlimited quantity of paper currencyand redeposit it later on at par. By contrast, within-year prepayment of taxes is possible but practically limited to the amount of the tax liability. (Between tax years a typically nonzero interest rate based on the market yield of short-term U.S. obligations applies.)
Similarly, if the amount that can be kept in reserve accounts is limited to an amount below the amount that banks would like to get a zero interest rate on because other rates are negative, the zero interest rate on a limited quantity of reserves will not prevent other rates from going negative. Thus, a zero interest rate on reserves does not create a zero lower bound if the Fed limits the amount that banks are allowed to keep as reserves with the Fed. I welcome comments on this possibility.
Note: See the links in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” to see how to make the paper currency interest rate negative by having paper currency very gradually depreciate relative to electronic money. This is related to the general principle that–like a limitation on quantities–the ability of an asset to change in price can prevent it from creating a zero lower bound. When the price is fixed by the government in a crawling peg, the price track needs to be chosen quite carefully (in a way I discuss) in order to avoid arbitrage opportunities. But when an asset price is determined by the market with very little government intervention (and no intervention by anyone else who has deep pockets and cares little about profit and loss), it will naturally follow a stochastic price track that does not create a zero lower bound.
See the closely related post "How the Fed Could Use Capped Reserves and a Negative Reverse Repo Rate Instead of Negative Interest on Reserves."