Only in the make-believe world of analytical models can negative nominal interest rates be argued to do any real good.
Last October, Andrew Bailey, governor of the Bank of England, ordered UK commercial banks to demonstrate their preparedness for the possible introduction of a negative interest rate policy (NIRP). From one perspective, this is merely a prudent step that enhances the central bank’s policy toolkit. From another, it is a further unwarranted and ill-advised step towards the complete abandonment of monetary control. The NIRP conversation sits alongside November’s £150bn extension of the Bank’s asset purchase facility, which will propel the annual growth rate of the money supply, currently 12%, to around 17% by March 2021. It would be remarkable if this development did not excite the inflation expectations of the UK public.
After more than a decade of very low interest rates in many advanced economies, we have become inured to cheap money and seduced by central bank propaganda that structural forces – debt, demographics and inequalities of income distribution – are primarily responsible for this unusual state of affairs. Never underestimate the capacity of policy-makers to draw the wrong conclusions about economic behaviour. Rather than consider the possibility that the policy of persistently low interest rates might itself be responsible for disappointing economic performance, they are magnetically attracted to the notion that the current policy would be successful if only interest rates could be lowered even further, into negative territory. Negative interest rate policy is an extension of a flawed argument, reductio ad absurdum. The beatings will continue until morale improves!
Much of the blame for this psychosis can be traced to the elegant analytical models in common use among academics and central bank research departments. The most widely used of these models is labelled New Keynesian and consists of three key equations that describe macro-economic behaviour. These are: versions of the Phillips curve, a representation of the relationship between economic slack and inflation; a Euler equation, which connects the consumption decision and the interest rate; and a monetary policy (Taylor) rule, which sets the optimal path for interest rates for given departures of inflation and unemployment from target. Numerous conditions are imposed on the model, for example that policy-makers set policy in a time-consistent manner and that central banks change interest rates only gradually.