What should the Federal Reserve do if the economy starts to tank? Former Fed Chairman Ben Bernanke thinks one tool to consider is negative interest rates.
In the first of several pieces written for the Brookings Institution think tank, Bernanke says he believes that in the event of an economic slowdown, the Fed should give deep thought to a monetary policy tool that would effectively bring the nominal federal funds rate to below zero.
If used, the Fed would follow the path chosen by the Bank of Japan and the European Central Bank to boost their stagnating economies. The idea, Bernanke admits, sounds odd to many since it means that, instead of receiving interest on bank reserves, financial institutions are charged a fee on their deposits with the Fed.
The cost, theoretically, is then passed on to depositors, and incentivizes business and individuals to invest and spend their cash instead of hoarding it in the bank (although in Japan, it led to a spike in the sale of home safes).
While considered a long shot, Bernanke said the policy should be on the table because the Fed has already exercised other tools to fight the 2008 financial crisis, such as cutting short-term interest rates to near zero, offering forward guidance and implementing quantitative easing. In the event of a recession, these tools could have minimal impact since it requires deft communication and "it’s also possible that a new round might be less helpful than before."
Bernanke does admit to potential problems: It remains to be seen if the Fed can legally compel banks to pay them a fee for holding overnight cash, banks could face a profit squeeze, and people could just hold cash instead of paying the bank to do it for them. "I assess the probability that this tool will be used in the U.S. as quite low for the foreseeable future," he writes.
However, with some economists predicting that a recession could come sooner rather than later, it's not a crazy scenario to imagine a world of negative interest rates in the U.S. if forward guidance or rate cuts fail. "In that scenario," writes Bernanke, "a policy of modestly negative interest rates might be a reasonable compromise between no action and rolling out the big QE gun."