Is Carnegie Mellon’s Marvin Goodfriend about to become a monetary policy superstar or is he leading the Fed down the primrose path into a black hole? His paper, “THE CASE FOR UNENCUMBERING INTEREST RATE POLICY AT THE ZERO BOUND” was a hit at the Jackson Hole Symposium– the little soiree for Central Bankers and the Criminally Insane. It would appear notwithstanding denials from Janet Yellen and others the Fed is preparing itself for negative interest rates. Or at least studying up.
Goodfriend’s exegesis on negative interest rates and the lower bound problem is a must-read but be prepared–even wonks and policy nerds will have trouble processing his analysis and rationale that advocates the use of negative interest rates by the Fed to eliminate the lower bound problem.
In Goodfriend’s own words negative interest rates take a little getting used to.
In I may summarize, according to Goodfriend and others for monetary to be efficient and effective when markets are under pressure short-term rates need to be about 2 1/2% lower than longer-term yields (i.e. 10 -year treasuries). Historical this differential is what it takes for monetary policy to get enough traction to induce investors to do otherwise unnatural acts. Given the institutional structure of the markets, it takes a steeply positive yield curve of 250bps to push (i.e. coerce) investors out the yield curve and down the credit curve accepting riskier assets in search of acceptable yield. With ten year treasuries at 1.5%, this implies central bank reserves and hence the inter- bank lending rate would need to be around -1%.
The idea of negative nominal interest rates takes some getting used to, but it should be possible to make the public aware eventually that such flexibility in short term interest rates is well worth it to provide better employment security and more secure lifetime savings. –Marvin Goodfriend
So why wouldn’t investors just hold cash in the form of paper money. Goodfriend’s logical extension is to eventually get rid of paper currency altogether. On paper (pun intended) it is theoretically “interesting” (as in “how was your blind date last night?”) But Goodfriend’s solution might just turn out to be the pretty girl at the ugly party.
Perhaps, Goodfriend and central banker are conflating monetary policy prescriptions with how investors and consumers actually behave. Disconnecting monetary policy and short-term interest rates with real corporate finance that uses simple tools such as net present value, hurdle rates, and IRRs is the stuff massive asset bubbles are made of.
Individually most investors are dumb as bricks but as a whole, they are brilliant, yet ruthless. When they don’t understand something the tend to vomit in a projectile manner. You can read Goodfriend’s paper and see if most consumers and/or investors will understand it. And that is where the problem lies. Aristotle said horror vacui or nature abhors a vacuum and investors abhor uncertainty. And those are the only two things to be certain of.