Janet Yellen Says Fed Could Turn to Negative Interest Rates

We all know that the Federal Reserve has artificially kept interest rates low for quite some time. Central banks argue (incorrectly) that in times of economic downturn lowering interest rates can help stimulate the economy. But what happens when interest rates are already near zero and the economy turns south?

The Fed could turn to negative interest rates, where it actually charges depositors to keep their money. In fact, this is already happening in Europe as CNBC reports:

In Europe, negative interest rates have shown up in credit markets for the better part of a year as investors give up positive returns for a modicum of safety. The return of principal has become more important than the return on principal.

For example, it has become quite common for investors to pay the Swedish and Swiss governments to hold their cash, which is how we define negative interest rates. Investors get less than zero to park their money in bills and notes.

Ok, but that is Europe. That could never happen here right? In fact, the US is already pretty close, with some investors buying short-term treasuries with no return:

The U.S. government has held 46 Treasury-bill auctions since 2008 in which yields have been zero. In recent months, yields on 3-month bills have carried no yield twice, something the U.S. hasn't seen in modern memory.

In fact, Janet Yellen said the Federal Reserve could turn to negative interest rates if the economy turns sour while she was testifying on Capitol Hill earlier today. From Yahoo:

The Federal Reserve would consider pushing interest rates below zero if the U.S. economy took a serious turn for the worse, Fed Chair Janet Yellen said on Wednesday.

"Potentially anything - including negative interest rates - would be on the table. But we would have to study carefully how they would work here in the U.S. context," Yellen told a House of Representatives committee.

This would happen if the economy were to "deteriorate in a significant way," she said, adding that she believed negative rates "would have some at least modest favorable effect on banks' incentives to lend."

Even if the Federal Reserve decided to push interest rates into negative territory, it doesn't automatically mean consumers would see the same phenomenon at their local bank. However, if that did happen, its possible the government would look to implement additional measures in order to prevent consumers from withdrawing their money in cash and thereby avoiding negative interest rates.

The government could, eliminate cash, ban businesses from accepting it, and/or tax withdrawals. In fact, Citi's economist, Willem Buiter, has suggested exactly eliminating cash altogether. From Bloomberg:

Yes, Buiter's solution to cash's ability to allow people to avoid negative deposit rates is to abolish cash altogether.

Before looking at the practicalities of abolishing currency, we should first look at whether it could ever be necessary. Due to the costs of holding large amounts of cash, Buiter puts the actual nominal rate at which the move to cash makes sense as closer to -100bp. So, in order for a cash abolition to become necessary, central banks would need to be in a position where they wished to set nominal rates much lower than that.

Buiter does not have to go far to find an example of where a central bank may have wanted to set interest rates much lower to -100bp. He uses (a fairly aggressive) Taylor Rule to show that Federal Reserve rates should have been as low as -6 percent during the financial crisis.

Even more reason that now, more than ever, we need to pass a full audit of the Federal Reserve. Sign your petition to your representative and Senators today.

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