Kenneth D. Garbade and James J. McAndrews
The United States has slid into eight recessions in the last fifty years. Each time, the Federal Reserve sought to revive economic activity by reducing interest rates (see chart below). However, since the end of the last recession in June 2009, the economy has continued to sputter even though short-term rates have remained near zero. The weak recovery has led some commentators to suggest that the Fed should push short-term rates even lower—below zero—so that borrowers receive, and creditors pay, interest.
One way to push short-term rates negative would be to charge interest on excess bank reserves. The interest rate paid by the Fed on excess reserves, the so-called IOER, is a benchmark for a wide variety of short-term rates, including rates on Treasury bills, commercial paper, and interbank loans. If the Fed pushes the IOER below zero, other rates are likely to follow.
Without taking a position on either the merits of negative interest rates or the Fed’s statutory authority to fix the IOER below zero, this post examines some of the possible consequences. We suggest that significantly negative rates—that is, rates below -50 basis points—may spawn a variety of financial innovations, such as special-purpose banks and the use of certified bank checks in large-value transactions, and novel preferences, such as a preference for making early and/or excess payments to creditworthy counterparties and a preference for receiving payments in forms that facilitate deferred collection. Such responses should be expected in a market-based economy but may nevertheless present new problems for financial service providers (when their products and services are used in ways not previously anticipated) and for regulators (if novel private sector behavior leads to new types of systemic risk). This post supplements an earlier post in Liberty Street Economics that reviewed possible disruptions that could result from zero interest rates.
Cash and Cash-like Products
The usual rejoinder to a proposal for negative interest rates is that negative rates are impossible; market participants will simply choose to hold cash. But cash is not a realistic alternative for corporations and state and local governments, or for wealthy individuals. The largest denomination bill available today is the $100 bill. It would take ten thousand such bills to make $1 million. Ten thousand bills take up a lot of space, are costly to transport, and present significant security problems. Nevertheless, if rates go negative, the U.S. Treasury Department’s Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.
If rates go negative, we should also expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower.
Early Payments, Excess Payments, and Deferred Collections
Beyond cash and special-purpose banks, a variety of interest-avoidance strategies might emerge in connection with payments and collections. For example, a taxpayer might choose to make large excess payments on her quarterly estimated federal income tax filings, with the idea of recovering the excess payments the following April. Similarly, a credit card holder might choose to make a large advance payment and then run down his balance with subsequent expenditures, reversing the usual practice of making purchases first and payments later.
We might also see some relatively simple avoidance strategies in connection with conventional payments. If I receive a check from the federal government, or some other creditworthy enterprise, I might choose to put the check in a drawer for a few months rather than deposit it in a bank (which charges interest). In fact, I might even go to my bank and withdraw funds in the form of a certified check made payable to myself, and then put that check in a drawer.
Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees. Commercial banks might find their liabilities shifting from deposits (on which they charge interest) to certified checks outstanding (where assessing interest charges could be more challenging). If bank liabilities shifted from deposits to certified checks to a significant degree, banks might be less willing to extend loans, because certified checks are likely to be less stable than deposits as a source of funding.
As interest rates go more negative, market participants will have increasing incentives to make payments quickly and to receive payments in forms that can be collected slowly. This is exactly the opposite of what happened when short-term interest rates skyrocketed in the late 1970s: people then wanted to delay making payments as long as possible and to collect payments as quickly as possible. Some corporations chose to write checks on remote banks (to delay collection as long as possible), and consumers learned to cash checks quickly, even if that meant more trips to the bank, and to demand direct deposits. However, if interest rates go negative, the incentives reverse: people receiving payments will prefer checks (which can be held back from collection) to electronic transfers. Such a reversal could impose novel burdens on payment systems that have evolved in an environment of positive interest rates.
The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Kenneth D. Garbade is a senior vice president in the Money and Payments Studies Function of the Federal Reserve Bank of New York’s Research and Statistics Group.
James J. McAndrews is an executive vice president and the director of research for the Bank.
Traditionally & rationally interest rates become negative in collapsing environments/societies. Perhaps no surprises here.
When commentators call for negative interest rates, aren’t they calling for negative nominal rather than real interest rates? Maybe I’m missing something, but Mankiw and others have floated the idea of negative real rates for a while, and this article doesn’t mention that.
What about bank A/L valuation of bonds using discount factors where observed rates are negative? No one has addressed that question as far as I can find.
Just buy some physical gold, problem solved!
Thanks for the tips. Glad to see you guys are preparing everyone for negative IOER rates. By the way, ten thousand $100 bills do not take much space. See http://www.pagetutor.com/trillion/index.html And the Fed could always issue $10,000 and $100,000 bills.
So without the fiscal mechanism working, whats the point of lower rates? Is it to help the banking industry? who got us into this mess in the first place? or is it to help the corporate world? that has record profits and isn’t spending a dime? Who’s benefiting from lower rates now? It’s easy to point to who benefits from higher rates now, the ever increasing large deposit base… namely individuals with deposits. I can also tell you, as debtor country the idea of lower rates benefiting all makes sense, but it hasn’t or will it ever help underwater mortgage borrowers or credit card balances that are getting charged even higher rates now. So i ask the question again, who is this monetary policy helping now??
Brilliant article. I don’t think any of these things are reasons to not push IOER negative if the point is to push banks into making (negative expectation) loans, but I hadn’t thought about the incentive to pre-pay taxes and other ideas presented here. Essentially, a key observation is that not collecting money in the first place is a practice that earns zero interest…it’s just weird to think about that, but it’s a great observation and it really does lead to a whole line of interesting thought. Well done.