Could negative rates be next on the Fed's policy menu?

 Into the Futures: Trading the Fed’s ‘dot plot’
Into the Futures: Trading the Fed’s ‘dot plot’   

Last week, the Federal Reserve spooked markets by preserving the monetary policy status quo. Yet a few central bank watchers were more surprised by a new idea the central bank seemingly suggested: a negative interest rate.

The Fed's closely watched "dot plot" revealed that at least one committee member floated the idea that a fed funds rate below zero might be an appropriate target for the remainder of this year and next.

The forecast is widely thought to be the work of Minneapolis Fed President Narayana Kocherlakota, a non-voting member of the committee who is known for his dovish views. In her press conference last week, Fed Chair Janet Yellen made clear that a negative federal funds rate "was not something that we considered very seriously at all today."

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However, in an environment where prices are persistently low, negative rates mean that businesses and consumers are essentially paid to borrow money, which could serve as an important stimulative tool in times of crisis.

The idea has been floated in the U.K., and tried in the euro zone and Switzerland. Suffice to say, the fact that the concept is being floated in the U.S. is striking to some.

After all, the Fed has spent years noting that its benchmark rate is at the "zero lower bound," which forces it to take other actions in order to stimulate the economy, (i.e. purchase bonds) since rates can't be lowered any further.

Yet what if that bound is not a bound at all, but a Rubicon waiting to be crossed?

We're gonna need a bigger toolbox

For University of Michigan economics professor Miles Kimball, negative rates are both possible and inevitable.

Kimball has travelled the world talking about the effects of subzero rates with central bankers around the world—including Fed policymakers. His goal is to show policymakers that "it's actually really easy" to effectively make interest rates negative.

Moreover, he believes adding the tool to a central banking policy toolbox is critical to ending recessions and combating deflation.

"What I've been working on is trying to make sure that the intellectual foundation for negative interest rates is laid in time for the next recession," Kimball told CNBC in an interview. "It's important for people to realize that the zero lower bound is ultimately a policy choice, and it's a bad one. And it's something that come another big emergency, we can do away with."

The concept of negative rates can be thought of as such: if the equilibrium interest rate—the rate at which money would naturally be lent—is a percent per year, a central bank wanting to combat low prices could trim its target rate below 1 percent. That will cause excess money to be borrowed and invested, and hopefully boost inflation and growth.

Yet if the equilibrium interest rate is actually below 0 percent, then most holders of currency would rather suffer a guaranteed loss rather than lend their money out. This was prevalent during the depths of the Great Recession. In that case, even an interest rate of 0 percent would be contractionary rather than stimulative.

Former Fed chair Ben Bernanke's preferred solutions to this problem included purchasing bonds via quantitative easing (QE) and assuring Americans that rates would stay low for a very long time. Kimball, however, said the endeavor was doomed from the start.

"Maybe we should have done three times as much QE, but nobody knows what three times QE would have done. By contrast, negative interest rates is right there in standard theory," Kimball said, which means that we can predict its effects by using basic economic models and beliefs.

Kimball doesn't necessarily believe that negative rates would be appropriate in the U.S. given that the worst of the recession is over. However, the conditions may present themselves again within the next decade, and the Fed could be prepared to meet the challenge.

"By the next recession, the U.S. will be ready to employ negative interest rates," he predicted.

Although Yellen shot down the short-term potential for negative rates, she said last week that if "we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools, and [a negative rate] would be something that we would evaluate in that kind of context."

Solving the cash problem

Recently, the European Central Bank, as well as Switzerland, Denmark and Sweden, have all enacted negative policy rates. Cutting the federal funds rate below the zero mark would be similar. But even if the Fed choose to do that, businesses and consumers would not be coaxed into making investments rather than hoarding their cash, and interest rates would simply go to exactly zero.

In order to truly enact a negative rate, the Fed would have to go further.

Kimball proposes that central banks effectively make the rate of return on cash negative, by adjusting the conversion rate between paper money and electronic money.

Right now, when a $100 bill is deposited into an account, $100 is added to that account. However, a central bank could create a situation whereby that $100 deposit only led to a $98 increase in the account. That would mean paper currency would have a rate of interest of negative 2 percent, rather than its current 0 percent.

At the same time, the government could not require that businesses accept cash as legal tender. In the service of reducing the overall value of money, the parallel linkage between the two kinds of currency—paper and electronic—would be broken.

So how would the government defend taking your money away slowly?

"When there's inflation, zero interest rates are already taking money from you slowly." Kimball pointed out.

"Negative 4 percent for one year, for instance, would have been better than 0 percent for seven years," he said. "Avoiding negative rates isn't doing savers any favors, because the best thing you can do for them is get out of your recession fast."

No more time value of money?

In a negative-rate world, the critical concept known as the "time value of money," whereby money now is more desirable than the same amount of money later, would be flipped on its head.

As for floating bond agreements, if rates fell far enough below zero, the lender could find itself forced to fork over interest payments to the borrower. Meanwhile, the cash regime Kimball recommends would make the ability to pay in cash a gigantic advantage.

"Businesses have got to start planning for this," Kimball advised. "Any lawyer who writes a debt contract without stipulating what happens if the market price of a paper dollar is not equal to an electronic dollar has to wake up."

The economist added: "There's going to be some central bank that does what I'm suggesting, and the companies who didn't prepare for it are going to be disadvantaged."

—By CNBC's Alex Rosenberg.

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