Carnegie Mellon University

Marvin Goodfriend

July 01, 2017

The Case for Unencumbering Interest Rate Policy at the Zero Bound

In 1999, Marvin Goodfriend, the Friends of Allan Meltzer Professor of Economics, first explored the concept of negative interest rate policy. Since then, the concept has gone from theory to reality in much of the advanced world. So in 2016, Goodfriend revisited negative interest rates in a paper presented at the Federal Reserve’s annual Jackson Hole Economic Policy Symposium, making the case for unencumbering interest rate policy altogether so that negative nominal interest rates can be made freely available as a realistic policy option in a future crisis.

Overall, Goodfriend describes a widespread pessimism that is depressing the natural interest rate, the interest rate that central banks must follow in order to sustain full employment and low inflation. Several factors worldwide are contributing to this problem. Because the public debt is growing, taxes are expected to increase. In addition, income inequality is rising in many countries, while population is aging and population growth is falling — so fewer people are working to support Social Security and health care for the elderly.

Global gross domestic product is increasingly coming from less developed countries with less secure property rights, less stable politics and less security in old age, while productivity growth has slowed throughout the developed world. Moreover, dwindling support for liberalization of international trade suggests that gains from trade will slow or fall. Downside risks due to the incapacitation of monetary and fiscal stabilization policy could be adding to this list of pressures.

In the United States, for instance, the result is that the 10-year U.S. Treasury bond rate fell below 1.5 percent briefly in 2016 and ranges below 2.5 percent today. 

The problem for monetary policy is that low long-term interest rates leave little leeway for the cyclical decline of short-term rates below long-term rates during the recovery from recessions. The United States has experienced eight recessions since 1960. To stimulate recovery each time, the Fed pushed the federal funds rate more than 2.5 percentage points below the 10-year Treasury bond rate. On five of these occasions, the Fed cut the federal funds rate more than 3.5 percentage points below the bond rate.

Other countries have already pursued negative interest rate policy, Goodfriend points out. At the time of his presentation in Jackson Hole, short-term policy rates were -0.4 percent in the Euro area, -0.75 percent in Switzerland, -0.5 percent in Sweden, and -0.10 percent in Japan. Those rates were introduced in June 2014, December 2014, February 2015 and January 2016, respectively. But the rates can fall only so far below zero, Goodfriend adds, because if they fall too far, demand for currency would soar.