Next week, FedFin will issue an update to our 2015 paper – the first we believe that forecast the now all-too-clear financial-stability risk of negative interest-rates policy (NIRP). In the update, we’ll lay out not just how NIRP’s going so far — not well – but also what’s likely in the U.S. now that the FRB has acknowledged the active consideration of NIRP we highlighted last year to considerable consternation. NIRP’s prospects in the U.S. depend on a complex balancing act: will political risk cause the Fed to stay its NIRP hand or will the echo chamber in which central banks work convince the FRB that nothing can save us but itself? In short, will fear or pride win the day? A theological question, perhaps, but one on which our fortunes depend.
First to fear. The FRB lives in a granite fortress that protects itself from almost all of the riff-raff but the Members of Congress who compel the chair to show up twice a year. These humbling Humphrey-Hawkins hearings are a gauntlet of what’s-in-it-for-my-district (and therefore for me) questioning that Fed chairs usually deflect with a combination of flattery and jargon. But, as this month’s hearings demonstrated, the inscrutability shield Fed chairs once donned isn’t working because there is widespread recognition that the central bank’s monetary policy is ineffectual. Congress now is going for the jugular – see the House-passed bill and listen to the hearings if you’re in any doubt about how few friends the Fed has on both sides of the aisle.
Congress will probably leave the FRB unmolested for now because it can no more undertake fundamental central-bank reform than it can execute its even more critical missions like effective fiscal policy. However, that Congress will stumble over itself and ultimately drop the murder weapon doesn’t mean it won’t inflict some serious wounds. To prevent this, the FRB is in the fetal position, and anything as controversial as NIRP or as costly as defending IOER may thus be dropped in the course of frantic self-defense.
Can pride triumph over fear? The decision-driver here is whether the FRB decides that its institutional political risk is so great that it dare not take any more chances with still more innovative, untested policies or if it decides to take political risk to salvage its credibility along with pulling the U.S. macroeconomy out of its eight-year ditch. I think the FRB will come out of the hidey-hole if it has to and go for NIRP if it sees no better course – in essence, it will throw the hail-Mary pass I described earlier this week on Bloomberg’s Benchmark.
Because the FRB’s fear of Congress is validated by Congress’ anger at the Fed, the central bank will defer courage for as long as possible, proceeding instead with FOMC meetings that keep rates above NIRP but below anything like the normalized path predicted as recently as January 1. But, because this cautious path may well not work – it hasn’t so far – the FRB may well throw caution – and even itself – to the wind and go for NIRP. I think it knows how dangerous NIRP could prove – I sure hope it does – but with so few monetary policy options and so much volatility with such weak growth, anything is possible.