Former Fed President Urges Negative Interest Rates

A former president of the Federal Reserve just came out in support for negative interest rates, in effect, forcing consumers and companies to “pay to save,” as Federal Reserve chairman Janet Yellen is set to testify before Congress Wednesday and Thursday.

Former Minneapolis Fed President Narayana Kocherlakota now says in a new blog post that the central bank should use negative interest rates to stimulate the economy, which he says the U.S. government could exploit. The former Fed uber dove argues that the government should take advantage of the worldwide flight to the safety of U.S. bonds to do much more government spending on things like safer water, nuclear power plants, and bridges. Spending that would go beyond the $19 trillion federal deficit the U.S. government has already amassed.

“The low natural real interest rate is a signal that households and businesses around the world desperately want to buy and hold debt issued by the U.S. government,” Kocherlakota says, adding, “Yes, there is already a lot of that debt out there - but its high price is a clear signal that still more should be issued. The government should be issuing that debt that the public wants so desperately and using the proceeds to undertake investments of social value.”

In his blog post, Kocherlakota adds: “Such a move would be appropriate for three reasons: It would facilitate a more rapid return of inflation to target; it would help reduce labor market slack more rapidly; and it would slow and hopefully reverse the ongoing and dangerous slide in inflation expectations.”

But Kocherlakota, who retired and was replaced by former top Treasury official Neel Kashkari on January 1, also blasts the U.S. Congress and the White House for poor fiscal policy. In his post, entitled, “Negative Rates: A Gigantic Fiscal Policy Failure,” Kocherlakota says:  “Going negative is daring but appropriate monetary policy. But it is a sign of a terrible policy failure by fiscal policymakers.”

Market watchers believed it was Kocherlakota who plugged in negative rates on the central bank’s heavily followed “dot plot.” The dot plot shows anonymously where each Fed member thinks the fed funds rate will be at the end of the next two years and long-term. Kocherlakota effectively confesses in his latest column that, yes, “since October 2015, I’ve argued that the Federal Open Market Committee (FOMC) should reduce the target range for the fed funds rate below zero.”

Kocherlakota joins a growing drumbeat for negative interest rates as deflation worldwide looms. The theory is that if central banks set negative interest rates for overnight deposits — meaning, assessing fees against banks to park funds overnight at the central bank—then the banks won’t do that, but instead lend that money out to make money on the loans, stimulating the economy. Same theory for individual depositors, that they will invest, lend or spend rather than “pay to save.”

Already, five central banks--the European Central Bank, as well as the central banks of Denmark, Japan, Sweden and Switzerland – now have a negative interest rate policy. More than $6 trillion worth of government bonds around the world now sport negative yields, an amount that has doubled in just two months, says JPMorgan Chase (NYSE:JPM). The bank adds that a year and a half ago, there were no government bonds issued with negative yields anywhere in the world.

Former Fed Chairman Ben Bernanke advocated a scenario where the U.S. central bank drops rates below zero for the first time ever in order to add stimulus to the economy in the event the U.S. drops into a recession. “I think negative rates are something the Fed will and probably should consider if the situation arises,” Bernanke said in an interview in December. “Europe has demonstrated that negative rates are possible.” Former Fed Vice Chairman Alan Blinder has also advocated negative rates.

In late January, the Federal Reserve disclosed that it will stress test 33 of the nation’s banks on April 5 based on a scenario where the three-month U.S. Treasury bill hypothetically sticks below zero in the second quarter and stays there through the first quarter of 2019. The three-month U.S. Treasury bill briefly dipped to minus 0.05% last Oct. 2. The stress tests results will be released by the end of June.

Kocherlakota has been building his case for negative rates and bond yields. For example, he tweeted in early January that the drop in 5-year/5-year breakevens was a “very worrisome signal for Fed credibility.” This data point is set by market prices on U.S. Treasuries and securities. “Breakevens” show where market players and investors expect inflation is headed five to ten years from now, and the extra yield in Treasuries that investors will demand over that time frame when it comes to inflation. Basically, these “breakevens” are the difference between the five-year Treasury and the yield on an inflation-protected security with five years remaining to maturity.

But the breakevens have been declining, nearly a full percentage point since June 2014, which means the Federal Reserve is struggling to achieve its pledge to deliver 2% inflation over the long run. Meaning, deflation is here.

What should the government spend its money on from negative-yielding bonds? Kocherlakota says: “The current market real interest rate - which I would argue is actually above the natural real rate r* - is about 1% out to thirty years [emphasis is Kocherlakota’s]. This low natural real rate represents an incredible opportunity for the U.S. We can afford to do more to ensure that all of our cities have safe water for our children to drink.  We can afford to do more to ensure that our nuclear power plants won’t spring leaks.  We can afford to do more to ensure that our bridges won’t collapse under commuters.”