I have argued that economists should be very wary about advocating steeply negative nominal interest rates. This is a case of basing policy on models which assume what they need to prove. If we assume that changes in the level of real policy rates is the primary lever influencing demand – it is unsurprising that the solution to our problems is to abolish physical cash and set rates at lower, negative, levels.
I have outlined a host of concerns around these policies, including the fact that the causal relationship between real interest rates and consumption may be very different across demographic regimes and at different levels of interest rates. The doughnut objection remains the strongest case for no longer relying on interest rates to stimulate spending. I have also argued that the impact of negative rates on the profitability of the banking sector may result in very perverse effects.
We can now start to assess these opposing perspectives by considering the experience of economies like Switzerland, which set its policy rate at -0.75% on January 15th this year. The initial findings suggest that we should indeed be very careful about expecting our models to work as assumed.
This recent speech from the SNB is very revealing (pages 4-5). Their policy of negative policy rates is deemed successful almost entirely because of its impact on the exchange rate and the differential yield on government securities in Switzerland and abroad. In fact, long-term domestic mortgage rates are slightly higher than they were at the beginning of the year. Banks have raised domestic lending rates relative to the policy rate, precisely to compensate for declining profitability.
Reflecting the intrinsic contradictions in these policies, the SNB is encouraged, for reasons of financial stability, that interest rates to households have not fallen commensurately – because if they did it would risk creating a housing bubble. Quite right too: negative policy rates may not cause financial instability, because they may not in fact succeed in lowering rates!
Those advocating steeply negative interest rates (and abolishing cash) should think again. Models that assume what you want to prove should be abandoned – start with how the world works.
There is an obvious policy prescription for a demand shortfall: make transfers payments to households. We have the empirical evidence. If we want independent central banks to do this, subject to an inflation target, start by giving them the power.