Negative and ultra-low interest rates have become the norm for the developed world. The phrases “lower for longer” and “new normal” are now accepted as facts rather than predictions. But, how low is too low?
For many developed world economies, rates remain low in order to combat stagnation as growth slows. Negative rates are a side effect of these deep, fundamental economic issues.
That brings up some big questions: How low? And for how long?
New research by Markus K. Brunnermeier and Yann Koby addresses this issue. They’ve tried to determine the point at which lower policy rates lose their stimulative effect.
Their research shows that lowering interest rates too far can be contractionary instead of stimulative. And the consequences are profound.
How quantitative easing really works
Before the Great Recession, the Fed Funds rate was the Fed’s main way of transmitting monetary policy. The fear then was that holding its policy rate too low for too long would cause inflation pressures to rise dramatically.
But times have changed. Now, the problem is precisely the opposite. The need to provide more stimulus has led to quantitative easing… and eventually to negative interest rates.
The process of quantitative easing is not as esoteric as it sounds. A central bank buys bonds or mortgages, typically from banks. This provides banks with reserves (cash) for assets. Banks then turn around and lend to individuals and businesses at lower interest rates than before. Economic growth ensues.
Individual banks are responsible for transmitting the policy to the economy. This means (as Brunnermeier and Koby point out) that the order of the stimulus matters.
Banks profit from loaning money out and holding bonds. So, when the Fed cuts interest rates, the value of the loans increases, which benefits the bank.
If the Fed decides it needs to conduct QE, the bank is able to sell these loans and bonds to the Fed at elevated prices. This is another benefit for the individual bank.
Eventually, this virtuous cycle ends because banks do not have endless expensive assets to sell to the Fed. This is where the “reversal rate” comes into play.
Why the reversal rate is a big problem
By lowering rates too far, a central bank removes the incentive for banks to lend. Without lending at lower rates, the bank has fewer of the assets to sell to the Fed and more volatile short-term deposits.
This breaks down the transmission of policy and creates a point at which lowering rates actually slows economic growth—the “reversal rate.”
This is why quantitative easing should always follow the lowering of interest rates. Otherwise, the higher asset prices accrue to the central bank, and the stimulus is inconsequential as quantitative easing has run its course.
This theory is not without some irony. Oddly, it negates the notion of negative and ultra-low interest rates being inherently inflationary. In fact, ultra-low rates could be disinflationary.
While the reversal rate has negative economic consequences, this does not affirm the fear expressed by the media that all negative rates are harmful. Negative rates only become harmful when they fall below the reversal rate.
A reversal rate would suggest that monetary policy has less of a margin in which to effectively operate than before. At its latest meeting, the Fed’s dot plot of projections put the “neutral” long-term rate at 2.875%, down from 4.25% at the beginning of 2012.
Assuming the US reversal rate rarely moves and is near zero, the overall monetary policy area is shrinking. In a sense, this means the Fed’s policy range shrank from 4.25% to 2.875%, which causes policy to be more difficult to execute.
In this situation, policy mistakes are more costly because there is not much in the economic toolkit to work with. It also means that quantitative easing may not be as effective as in previous cycles. In essence, if a reversal rate exists, it makes the need for infrastructure development a necessity to stimulate the economy.
The idea of a reversal rate is new. In fact, there has yet to be agreement among economists on whether it exists, and if it does, what it might be for the US. But it makes intuitive sense that there exists a level where stimulus leads to restriction.
Central banks need to rethink the process and policies by which their new unconventional tools are delivered and how long these tools should be maintained. Figuring out how monetary policy can stimulate after reaching the reversal point will prove difficult. Understanding how far is too far, and how long is too long, will be the next great central bank challenge.
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By Samuel Rines