In Search of the Effective Lower Bound
The self-described "BondFreak" noticed a shift in Fed vocabulary from "zero bound" to "effective lower bound".
Powell Ready to Cut Rates to "Effective Lower Bound" via "Conventional" Policy
A Google search for "effective lower bound" just happened to turn up my own post Powell Ready to Cut Rates to "Effective Lower Bound" via "Conventional" Policy.
Here are the pertinent statements from a speech Powell made on June 4 at a "Conference on Monetary Policy Strategy, Tools, and Communications Practices".
Emphasis is mine.
While central banks face a challenging environment today, those challenges are not entirely new. In fact, in 1999 the Federal Reserve System hosted a conference titled "Monetary Policy in a Low Inflation Environment." Conference participants discussed new challenges that were emerging after the then-recent victory over the Great Inflation. They focused on many questions posed by low inflation and, in particular, on what unconventional tools a central bank might use to support the economy if interest rates fell to what we now call the effective lower bound (ELB). Even though the Bank of Japan was grappling with the ELB as the conference met, the issue seemed remote for the United States.
The next time policy rates hit the ELB—and there will be a next time—it will not be a surprise. We are now well aware of the challenges the ELB presents, and we have the painful experience of the Global Financial Crisis and its aftermath to guide us. Our obligation to the public we serve is to take those measures now that will put us in the best position deal with our next encounter with the ELB.
The big difference between then and now is that the federal funds rate was 5.2 percent—which, to underscore the point, put the rate 20 quarter-point rate cuts away from the ELB. Since then, standard estimates of the longer-run normal or neutral rate of interest have declined between 2 and 3 percentage points, and some argue that the effective decline is even larger. The combination of lower real interest rates and low inflation translates into lower nominal rates and a much higher likelihood that rates will fall to the ELB in a downturn.
Why the shift?
I believe the answer is the Fed no longer believes zero is the ELB. So this leads to a different question.
Where the Heck is the ELB?
First, we need a definition.
What's the Definition of ELB?
Effective Lower Bound is the point beyond which further monetary policy in the same direction is counterproductive.
I propose the Bank of Japan and the ECB are already below ELB. I further propose the ELB can never be negative but it can be well above zero.
Reversal Interest Rate
I happened across an article just the other day on the ELB moving target.
Please consider The Reversal Interest Rate
The “reversal interest rate” is the rate at which accommodative monetary policy “reverses” its intended effect and becomes contractionary for the economy. It occurs when recapitalization gains from duration mismatch are more than offset by decreases in net interest margins, lowering banks’ net worth and tightening its capital constraint. The determinants of the reversal interest rates are (i) banks asset holdings with fixed (non-floating) interest payments, (ii) the strength of the constraints that they face, (iii) the degree of interest rate pass-through to deposit rates, and (iv) the initial capitalization of banks. Furthermore, quantitative easing increases the reversal interest rate and hence should only be employed after interest rate cut is exhausted. Over time the reversal interest rate creeps up, since the capital gains effect fades out as longterm bonds holdings mature while the net interest margin effect does not.
The authors propose the rate can be above or below zero but it gets higher over time especially if QE is involved.
Bank Lending Constraints
In our model, as in reality, the risk-taking ability of the banking sector is constrained by its net worth. If the latter is high enough so that the constraint does not bind, or if capital gains are strong enough to actually increase net worth, then an interest cut generates the boom in lending that the central bank seeks to induce. However, if capital gains are too low to compensate the loss in net interest income, net worth decreases to the point where the constraint binds, limiting banks’ ability to take on risk. At that point, i.e. at the reversal interest rate, any further interest cuts generate a decline in lending though the net-worth feedback. Moreover, an interesting amplification mechanism emerges. As the negative wealth effect further tightens banks’ equity constraint, banks cut back on their credit extension and are forced to increase their safe asset holdings. As safe assets yield lower returns, banks’ profits decline even more, forcing banks to substitute out of risky loans into safe assets, which in turn lowers their profit, and so on.
Huge Failure Already
I discussed lending constraints the other day (and many time priors) in ECB's New Interest Rate Policy "As Long As It Takes" Huge Failure Already
Banks Lend Under Two Conditions
- They are not capital impaired
- They believe they have good credit risks
If either condition is false, then banks don't lend.
Negative interest rates did not induce either Japanese or European banks to lend.
What's Going On?
Either European banks are more capital impaired than the ECB wants everyone to believe, or banks believe there are few good credit risks worth taking.
Take your pick. I expect both are true.
We then uncover the determinants of the reversal interest rate in our baseline model. The reversal interest rate depends on bank assets interest rate exposure, the tightness of financial regulation, as well as the market structure of the banking sector. If banks hold more longterm bonds and mortgages with fixed interest, the “stealth recapitalization” effect due to an interest rate cut is more pronounced, and the reversal interest rate is lower. Stricter capital requirements rise the reversal interest rate. Lower market power, which decreases profits, also generates a higher reversal interest rate. For example, in a negative interest rate environment, innovations that allow depositors to substitute bank accounts for cash more easily hurt the banks’ margins and raise the reversal interest rate; if such innovation occurs below the reversal interest rate, it directly feeds back into lower lending.
The article mentions "stealth recapitalization" of banks. I have discussed that many times recently but in a different context.
The Fed pays interest on excess reserves but the ECB charges them. Whereas the Fed gave free money to banks, the ECB charged the banks for excess reserves it forced into the system.
Negative Interest Rates Are Social Political Poison
In contrast to the authors, I do not believe negative interest rate policy can ever work as it violates basis economic principles on time preference and the time value of money.
Moreover, a dive below the ELB supports the position I presented on September 23: Negative Interest Rates Are Social Political Poison
- I like the notion of ELB, or Reversal rate if you prefer.
- I do not believe it can ever be below zero but accept the notion it can be higher.
- It is not fixed
- It varies bank-by-bank and changes over time
Chasing Tail Madness
Searching for the ELB is like chasing tails.
It's only by accident can a central bank catch the tail. But even if it does catch the tail, the tail can still move. Further efforts to re-catch the tail are as likely as not to be in the wrong direction.
With that, let's return to the BondFreak's question. Why the word change?
Perhaps the Fed is aware the ECB is on the wrong course, negative rates are counterproductive, or the ELB just might be above zero.
Perhaps it's meaningless happenstance.
Deeper Down the Rabbit Hole
Yesterday, I noted Draghi Open to MMT and a People's QE
Every attempt to fix the perceived problem of "too low inflation" goes deeper and deeper down the rabbit hole.
It's economic madness, yet, here we are.
The solution is to let the free market set interest rates rather than a tail-chasing consortium of economic wizards who have never spotted a bubble or a recession in real time.
Of, course, we also need to get rid of central banks and fractional reserve lending.
Unfortunately, central banks will not vote to abolish themselves. It's also certain that government efforts to take direct control of money will be even worse than the actions of central banks.
A position is gold is the best counter to monetary policy madness.
Mike "Mish" Shedlock