Negative interest rates will be needed in the next major recession or financial crisis, and central banks should do more to prepare the ground for such policies, according to leading economist Kenneth Rogoff.
Quantitative easing is not as effective a tonic as cutting rates to below zero, he believes. Central banks around the world turned to money creation in the credit crunch to stimulate the economy when interest rates were already at rock bottom.
In a new paper published in the Journal of Economic Perspectives the professor of economics at Harvard University argues that central banks should start preparing now to find ways to cut rates to below zero so they are not caught out when the next recession strikes.
Traditionally economists have assumed that cutting rates into negative territory would risk pushing savers to take their money out of banks and stuff the cash – metaphorically or possibly literally – under their mattress. As electronic transfers become the standard way of paying for purchases, Mr Rogoff believes this is a diminishing risk.
“It makes sense not to wait until the next financial crisis to develop plans and, in any event, it is time for economists to stop pretending that implementing effective negative rates is as difficult today as it seemed in Keynes’ time,” he said.
“The growth of electronic payment systems and the increasing marginalisation of cash in legal transactions creates a much smoother path to negative rate policy today than even two decades ago.”
Countries can scrap larger denomination notes to reduce the likelihood of cash being held in substantial quantities, he suggests. This is also a potentially practical idea because cash tends now to be used largely for only small transactions. aw enforcement officials may also back the idea to cut down on money laundering and tax evasion.
The key consequence from an economic point of view is that forcing savers to keep cash in an electronic format would make it easier to levy a negative interest rate.
“With today’s ultra-low policy interest rates – inching up in the United States and still slightly negative in the eurozone and Japan – it is sobering to ask what major central banks will do should another major prolonged global recession come any time soon,” he said, noting that the Fed cut rates by an average of 5.5 percentage points in the nine recessions since the mid-1950s, something which is impossible at the current low rate of interest, unless negative rates become an option.
That would be substantially better than trying to use QE or forward guidance as central bankers have attempted in recent years.
“Alternative monetary policy instruments such as forward guidance and quantitative easing offer some theoretical promise for addressing the zero bound,” he said, in the paper which is titled ‘Dealing with Monetary Paralysis at the Zero Bound’.
“But these policies have now been deployed for some years – in the case of Japan, for more than two decades – and at least so far, they have not convincingly shown an ability to decisively overcome the problems posed by the zero bound.”