Friday, September 11, 2015

Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

A common argument against the Fed raising interest rates next week is the asymmetry in risks that it faces. If it keeps rates low too long and sets off inflation, no problem: it can quickly hike rates a few times to bring prices back in line. However, if it boosts rates too early and an unintended slowdown sets in, the Fed won't have room to cut a few times in order to fix its mistake. That's because the Fed is at the zero lower bound, the edge of the world in monetary policy terms. To avoid this conundrum, the Fed should hold off as long as possible before raising, at least until it "sees the whites of inflation's eyes."

As Paul Krugman points out, the asymmetry argument is only a recent one. Historically U.S. interest rates have hovered far above zero. If the Fed made a mistake, it didn't have to worry about falling off the edge of the world in order to fix the situation, it could simply ratchet rates down a few times. Rather than waiting till the last minute to see the whites of inflation's eyes before hiking, the FOMC only had to hear the creak of inflation at the door.  

I don't buy the current asymmetry argument. I might have bought it back in 2013, but the data has changed.

Over the last year, Sweden, Switzerland, Denmark, and the ECB have all demonstrated to the world that central banks can safely lower rates into negative territory without setting off the sorts of ill effects that economists have always feared, the main one being a race into 0% yielding cash. The theory here is that if a central bank reduces rates to, say, -0.1%, then paper cash—which pays a superior 0% return—starts to look pretty attractive. An arbitrage process begins whereby central bank deposits are converted into cash until all deposits have disappeared. Thus rates can't be reduced below 0%.

Evidence over the last 12 months shows otherwise. Denmark's Nationalbank has kept its deposit rate at -0.75% since early February. Danes, however, are not scrambling for banknotes, as the chart below shows. After seven months of negative rates, cash and coin outstanding are growing at a rate that lies pretty much at its two decade average.

The Swiss National Bank has maintained a -0.75% overnight rate since January, yet there's been no spike in Swiss paper franc demand, as the next chart shows. In fact, cash outstanding seems to be growing at one of its slowest rates in years.

We'd expect the demand for Swiss cash to be especially sensitive when interest rates fall below zero because the SNB issues the world's largest value banknote; the hefty 1000 sFr. The more valuable the banknote the lower the cost of storing wealth in cash form. These carrying costs are particularly important in determining the profitability of flight into cash at negative interest rates. A central bank can push rates a sliver below 0% without setting off a flight out of deposits into banknotes as long as there are inconveniences in storing cash. The greater these inconveniences, the larger that sliver.

The fact that the SNB has been able to keep rates at -0.75% for seven months now without setting off a stampede into 1000 notes indicates that the burdens of holding Swiss currency are higher than everyone had previously thought. It would seem that investors would rather lose 0.75% each year than bear the costs of storing 1000s. At some negative interest rate, maybe -1.5%, the flight into Swiss notes will start. But it hasn't yet. As for the U.S., its highest value banknote is the lowly $100, so it's fair to assume that the costs of storing U.S. paper money are significantly higher than Swiss money. Which means that if the Swiss can safely cut to -0.75% without setting off cash arbitrage, the Fed should be able to descend to at least -1.0% before panic ensues.

The second greatest fear surrounding sub zero U.S. rates has always concerned money market mutual funds. The worry here is that should the Fed reduce rates too deep, a financial intermediary known as a money market mutual fund (MMMF) will 'break the buck,' causing panic and terror among ordinary investors.

MMMFs are like regular mutual funds except their share price stays fixed at US$1.00. Investors can cash out at that price whenever they want, enjoying low but steady dividend payments until then. MMMFs maintain par conversion by investing in safe, highly liquid short term debt. However, if the Fed were to drive short term rates into negative territory, MMMFs would be forced to invest in assets that promise a negative return. $1000 invested in t-bills, for instance, would be worth only $999 upon maturity. That means that an MMMF simply wouldn't have a sufficient quantity of assets to allow everyone to redeem their shares at US$1.00. The fund will "break the buck," or mark its share value down to something like 99 cents to allow for full redemption. Since MMMFs are supposed to be cash-like—in fact, many of them offer cheque-writing capability—such a development would be disastrous, or so goes the story.

I don't consider breaking the buck to be a terrible outcome, but even if it is, European money market mutual funds—faced with negative interest rates—have already found an ingenious way to avoid it; a Reverse Distribution Mechanism. Rather than reducing redemption below par, MMMFs simply dock the number of shares that each shareholder has in his or her account. For example, as rates slide below zero, instead of 100 units being worth only $0.99 each, a shareholder forfeits one unit and ends up with 99 units worth $1.00 each. The deeper rates fall, the less units each investor owns. The genius of this patch is that the purchasing power of each share stays constant, but the negative interest rate is efficiently passed on to the owner of the MMMF.

So fears of a dash into cash at 0% and a collapse of MMMFs are just bogeymen. If the Fed hikes to 0.5% this month—and this proves to be a mistake—it still has plenty of room to make things right. Given how well Europe has coped over the last twelve months, the Fed can easily cut rates another 1.5% to -1.0%; that's six quarter-point reductions or thirty ten-point cuts. Only when rates falls beyond Swiss or Danish levels, say to -1.0%, will the Fed find itself in truly asymmetrical territory. (If necessary, here are some simple ways to allow for even more negative rates).

To be clear, that doesn't mean I think the Fed should hike rates next week. The fact that the FOMC continues to undershoot its 2% core inflation target would seem to indicate that holding off might be the right thing to do. Rather, I don't think that Fed policy makers need to wait to see the white's of inflation's eyes before they hike, they need only wait to hear the creak of inflation at the door.


  1. What if the fed raises rates by 0.25% and the economy tanks? Is 1.5% enough room to the downside to stimulate aggregate demand?

  2. JP,
    Have you stopped to consider that increasing currency in circulation could be a good thing for the nominal economy? Could you envisage a scenario where base money expansion is distributed and circulated in the nominal economy, rather than being held under lock and key as ephemeral excess reserves?

    Money is meant to be used. If people demand currency, let them have as much as they like: it's an interest free loan to the government, after all. It's a good trade: everybody gets what they want (except banks).

    They pay 33bp overnight deposits in Greece, you'll notice. And the banks have decided that you are only entitled to possess $70 of your property each day. Do you also have a chart of how Greek currency demand is very low and slow?

    Consider that changes in currency in circulation is not equivalent to currency demand. You might be right about Denmark, or you could be horribly, horribly wrong. You cannot know which.

    You are also wrong on Switzerland by the way. Institutions want their banknotes, and banks simply refuse, lawlessly.

    Negative rates might be all sunshine and roses, or negative rates might be like iron fists and peonage. You could could be horribly, horribly wrong. You cannot know which.

    1. I mentioned that news article in this blog post:

      The fact that I've only read one report on this tells me that the pension fund in question was probably an outlier. If Swiss banks we're systematically restricting access to 1000s, there should be more stories about it. And we'd expect to hear accounts of 1000s rising to a premium relative to deposits and other paper denominations. But I haven't heard of this occurring.

      And even if they are restricting access to cash, that's a feature, not a bug. Since people are being impeded from ridding themselves of negative yielding deposits by getting into cash, they'll be forced to spend it on stuff, and that will lead to NGDP growth.

    2. Hi JP,
      Well, I'd be just satisfied with hearing that the swiss pension fund actually got their physical cash out of their commercial bank.

      Given the banking fragility displayed in 2008, I'd rather really hold a direct banknote claim on the central bank than a deeply subordinated unsecured claim on a commercial bank. Demand deposits are lower priority than banknotes.

      You are, after all, asking for a titanic cram-down of now-senior cash holders into a subordinated bank demand deposit. This destroys value -- ask anybody ever involved in a bankruptcy workout. Forcing a senior claim to accept subordinated paper strips asset value and is a technical default.

      Who exactly is on the other side of that trade? Somebody benefits when claimsholders are forced to accept lower-value assets. Could it be the banks? (Serious question).

  3. Interesting application of your earlier negative rate theme.

    There is a policy continuity issue, I think. Having dumped trillions of QE into the system without having considered negative rate territory as a proactive complementary easing strategy, it seems awkward now to consider it as a contingent easing strategy in response to a potential premature tightening.

    I would recommend holding off on this plan until the upcoming 2090 installment of QE, where policy consistency can be exhibited throughout the process.


    1. Lol. Hopefully the Fed can get by the awkwardness. They'd be doing the world a favour.