On Gradualism in Negative Interest Rate Policy

Noah Smith does a service by reviewing the debate on negative interest rate policy in his Bloomberg View column “Maybe We Shouldn’t Be So Positive About Negative Rates.” Despite the title, which I suspect (based on my own experience as a Quartz columnist) was chosen by Noah’s editor rather than by Noah himself, Noah sums it up in this rather positive way:

So while Miles is an important and visionary thinker on monetary policy, and his ideas will be very useful if another crisis comes, I’m personally a bit wary about deploying them in relatively normal times.

This is not an uncommon view. Indeed, you can see it evidenced by several luminaries at the Brookings conference on negative interest rates on Monday in reaction to my talk and the panel discussion afterwards.

Let me discuss Noah’s perspective in the context of the US, Japan, and the Eurozone, then conclude by talking more generally about the set of nations and regions that conduct independent monetary policy. 

Negative Rate Policy in the United States: To get the record straight, I do not currently advocate even mildly negative interest rates for the United States. So to the extent that “relatively normal times” refers to the current economic situation in the United States, I have no disagreement. I have said that deep negative rates would have been appropriate for the United States in 2009. But I hope no one classes 2009 as “relatively normal times.” Whatever the uncertainties about what side effects such a policy might have had, shouldn’t we wish now that we had tried the experiment of a deep negative interest rate policy (along the lines I have recommended) in 2009? The reason we didn’t was the intellectual framework had not been laid out for such a move at that time. My hope is that by the time the next severe recession hits the United States, that we can be ready. 

I think it is very important to fight the idea that the United States had an acceptable monetary policy performance during the Great Recession. As I have said many times, Ben Bernanke is a hero for doing what he did toward making US monetary policy as good as it was during the Great Recession. I don’t underestimate the difficulty of developing and getting consensus for new monetary policy tools in real time during a crisis. But in absolute terms, US monetary policy during the Great Recession is totally unacceptable as something to repeat. To speak ethically, anyone who encourages complacency about our monetary policy toolkit by suggesting that we should simple handle the next serious recession with the monetary policy tools the US used during the Great Recession alone will have to bear a portion of the guilt for the likely poor outcome if this course is, in fact, pursued.

Negative Rate Policy in Japan: After more than two decades of slow growth and deflation or near-deflation, Japan can be characterized as being in “normal times” only if one is willing to give up and accept “secular stagnation” as the new normal. Back in 2012, before I had realized the potential of negative rate policy, I remember an exchange with Noah in which we both agreed about the virtues of being willing to do big experiments. Inspired by that exchange, I wrote “Future Heroes of Humanity and Heroes of Japan” recommending that the Bank of Japan try massive asset purchases of roughly the magnitude they have in fact tried. They deserve a great deal of honor for trying that bold experiment. But it is not at all clear that it is enough. The Bank of Japan has begun gingerly experimenting with mild negative rates as well. 

Japan is a difficult case for negative interest rate policy because the fraction of transactions carried out in paper currency is currently very high. So though there is real tradeoff if one delays urgently needed stimulus, gradualism in negative interest rate policy may make sense for Japan. But it is becoming clear that the Bank of Japan will probably need to go to lower negative rates than its current -.1% to get the Japanese economy to the level of economic activity it ought to have. So if it chooses not to move more quickly, the Bank of Japan should gradually reduce the key interest rates it controls, 10 basis point (.1%) at a time, while keeping a close eye on data to watch for side effects and gradually introducing either a very small negative paper currency interest rate with the depreciation mechanism that Ruchir Agarwal and I recommend in our IMF working paper “Breaking Through the Zero Lower Bound,” or gradually introduce policies from the a la carte menu of alternative policies to defang paper currency as a barrier to low interest rates that Ruchir and I laid out in our Brookings presentation on Monday. There is a lot more to say about that kind of gradualist path for Japan that I will leave to another post. 

Negative Rate Policy in the Eurozone: Because the Eurozone has already experimented with deeper negative rates than Japan, and as a whole uses paper currency for a smaller fraction of transactions, it should be able to go to deeper negative rates more quickly than Japan. Still, although speed does have benefits, I have no objection to a considered judgement by those who actually bear the weight of monetary policy decision-making to go down step by step, 10 or 20 basis points (.1% or .2%) at a time. And indeed, given how much expectations matter, it would be very powerful for the European Central Bank to announce that it would continue to reduce rates by 10 basis points at each meeting–or even 5 basis points every other meeting–until either (a) it appeared there was a danger of overshooting the ECB’s inflation target of 2% or (b) other serious side effects emerged (that could not be managed by appropriate complementary policies). I think that this is, in fact, how negative interest rate policy will develop. 

Conclusion: A cogent argument can be made that the world does too little macroeconomic experimentation. I believe the economies of countries that are reasonably well-run to begin with (say the OECD countries plus some others) are robust enough that they will not fly to pieces from a bit of experimentation. If they were likely to fly to pieces from a bit of experimentation, they would fly to pieces with every other unavoidable shock of any size that hit them. 

Even seeing if the economy will fix itself if we do nothing, however “nothing” is defined, is worth trying. But in the realm of macroeconomic stabilization, I view “nothing” as something that–to a reasonable approximation–has been tried and has failed. Anything one does has consequences. There is no true “inaction.” There is only “Do A” or “Do B.” 

It is a good thing when nations try a variety of policies among the set of policies that can be easily reversed. Louis Brandeis famously called US states “laboratories of democracy.” The many nations and regions with independent monetary policy constitute “laboratories of monetary policy.” It is a good thing, deserving of honor, for central bankers in different nations to make their own judgments about what experiments are worth trying. And it is a good thing if central bankers make some effort to carefully test novel approaches when well-worn approaches do not seem to be working well.