The Trump administration has selected candidates for at least two of the three open positions on the Federal Reserve’s Board of Governors, according to people with direct knowledge of the decision. The expected nominees include Randal K. Quarles, a Treasury Department official in the George W. Bush administration, and Marvin Goodfriend, a former Fed official who is now a professor of economics at Carnegie Mellon University.
Goodfriend is described in the piece as a sceptic of the Fed’s bond-buying, especially its purchases of mortgage-backed securities because these ostensibly favour the housing sector over other areas of the economy. He is also someone who has expressed sympathy for binding the Fed’s policy decisions with simple rules.
This might not sound like someone inclined to support the monetary policies desired by a self-professed “low-interest rate person”. However, it’s also worth noting that Goodfriend’s opposition to balance sheet expansion is paired with a radical willingness to embrace deeply negative rates. Negative rates are the one policy option Fed officials have studiously avoided discussing in public even though they have been adopted by the European Central Bank, the Bank of Japan, the Swedish Riksbank, and of course the Swiss National Bank.
Goodfriend presented on the subject at the Federal Reserve Bank of Kansas City’s economic symposium at Jackson Hole in 2016. To Goodfriend, refusing to let nominal interest rates drop below zero is analogous to the gold standard and exchange rate pegs:
The zero interest bound is an encumbrance on monetary policy to be removed, much as the gold standard and the fixed foreign exchange rate encumbrances were removed, to free the price level from the destabilizing influence of a relative price over which monetary policy has little control—in this case, so movements in the intertemporal terms of trade can be reflected fully in interest rate policy to stabilize employment and inflation over the business cycle.
Of course, deeply negative interest rates are difficult to impose when paper money exists as an alternative. Even after costs of storage, the effective lower bound probably isn’t much below -1 per cent. Goodfriend’s proposed solution to this challenge is truly radical (emphasis ours):
The zero bound encumbrance on interest rate policy could be eliminated completely and expeditiously by discontinuing the central bank defense of the par deposit price of paper currency. The central bank would still stand ready to exchange bank reserves and commercial bank deposits at par; and it could stand ready to convert different denominations of paper currency at par. However, the central bank would no longer let the outstanding stock of paper currency vary elastically to accommodate the deposit demand for paper currency at par.
Instead the central bank could grow the aggregate stock of paper currency according to a rule designed to make the deposit price of paper currency fluctuate around par over time. The paper currency growth rule would utilize: i) historical evidence relating currency demand to GDP, ii) the estimated interest opportunity cost sensitivity of the demand for currency relative to GDP, and iii) the GDP growth rate.
The reason to abandon the pegged par deposit price of paper currency is analogous to the aforementioned reasons for abandoning the gold standard and fixed exchange rate: it is to let fluctuations in the deposit demand for paper currency be reflected in the deposit price of paper currency so as not to destabilize the general price level…The deposit price of paper currency would adjust flexibly much as floating exchange rates adjust to equilibrate the foreign exchange market when international interest rates differ from each other. More relevant, the flexible deposit price of paper currency would behave as it actually did when the payment of paper currency for deposits was restricted in the United States during the banking crises of 1873, 1893, and 1907.
In other words, the value of a paper dollar would no longer be guaranteed. It may say $10 on the front but if the policy rate were -10 per cent the piece of paper would only be worth $9. Here’s his conclusion (emphasis ours):
If the zero bound were removed completely, then interest rate policy could enable the public to enjoy the benefits of a fully stable purchasing power of money. Credibility against inflation is tied to credibility against deflation—the central bank would no longer shrink from action against inflation for fear of having to fall back with little room to act against recession…With inflation credibly under control, the public could safely hold long term nominal bonds free of inflation risk and minimize its exposure to negative short term interest rates.
Thus, we can imagine a mutually reinforcing equilibrium in which the public extends the maturity of its savings and the central bank with the public’s support is free to pursue negative nominal interest rate policy on occasion to act against a deflationary contraction in employment and output. The idea of negative nominal interest rates takes some getting used to, but it should be possible to persuade the public that such flexibility is well worth it to provide better employment security and more secure lifetime savings.
Alphaville looks forward to these ideas being discussed in Goodfriend’s confirmation hearings.
Related links:
Yellen on negative rates: we do not speak its name — FT Alphaville
