– September 20, 2019

Negative INterest Rate

President Trump has called for negative interest rates. He should be careful what he wishes for.

In a recent tweet, President Trump urged the Fed to lower interest rates.

The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt. INTEREST COST COULD BE BROUGHT WAY DOWN, while at the same time substantially lengthening the term. We have the great currency, power, and balance sheet….. [Capitals in original]

Could the Fed make interest rates on government debt negative and bring interest costs way down for the federal government and taxpayers? The short answer is no. The alleged benefit of lowering interest costs is not real. In addition, the federal government would find itself paying more on existing long-term debt in real terms — that is, in terms of goods and services.

The Federal Reserve sets certain interest rates, which then affect other interest rates in the economy. In particular, the Federal Reserve sets the interest rates it pays on required and excess reserves, and it could indeed make these rates negative. A negative interest rate on reserves means that, rather than paying banks to hold reserves, the Federal Reserve would charge banks for maintaining reserve balances.

As President Trump noted in another tweet, quite a few other countries already have negative interest rates. Two prominent central banks have set negative interest rates on excess reserves — the European Central Bank (ECB) and the Bank of Japan (BOJ).

The ECB has a negative interest rate on excess reserves. On June 11, 2014, it was lowered from 0.0 to -0.10 percent. It was reduced further thereafter, and was cut further still from -0.40 to -0.50 percent on September 18, 2019.

The BOJ has a tiered interest rate on reserves, and the lowest rate was lowered from 0.10 percent to -0.10 percent on January 29, 2016.

The interest rate paid on excess reserves in the United States is quite a bit higher than those offered by the ECB and the BOJ. It stood at 2.35 percent prior to August 1, 2019, when the Board of Governors of the Federal Reserve lowered it to 2.10 percent. Many expect the Fed will cut it again in the coming months.

The ECB and the BOJ implemented negative interest rates to raise inflation from very low levels compared to inflation targets of 2 percentage points per year. The purpose was not to lower interest costs for their related governments.

Have these negative interest rates increased inflation? No. In fact, a recent study of Japan by the Federal Reserve Bank of San Francisco provides evidence that the lowering of interest rates to -0.10 percent per year in Japan lowered expectations of future inflation. This lower expected inflation can be expected to result in lower future actual inflation as people adjust to lower interest rates and expected inflation.

Inflation in both the Eurozone and Japan is lower than in the United States, where interest on excess reserves is higher. Inflation is 1.3 percent per year in the Eurozone and 0.7 percent per year in Japan as measured by the Eurozone’s and Japan’s Consumer Price Indices from June 2018 to June 2019. (These are the latest available data.) The U.S. inflation rate from August 2018 to August 2019 is 1.8 percent per year.

At least compared to the United States, the Eurozone and Japan have lower inflation, not the higher inflation that would be suggested by usual discussions in the media and policy circles of lowering interest rates. How can this be?

All of the interest rates set by central banks are nominal interest rates — that is, rates in terms of currency. For example, a nominal interest rate of 2 percent on a loan means that a borrower must make an interest payment in currency equal to 2 percent of the value of the loan in currency. A nominal interest rate is the sum of the corresponding real interest rate and expected inflation. Hence, a central bank can achieve a lower nominal interest rate by reducing (1) the corresponding real rate or (2) inflation expectations.

Central banks can reduce real rates temporarily by surprising financial markets. But they can permanently reduce inflation expectations by committing to slower money growth. Empirically, the latter dominates: lower interest rates are associated with lower inflation over a long period of time, and the “long period of time” may not be all that long.

Why is lower inflation associated with lower nominal interest rates? Lower expected inflation means that lenders are paid back in currency that buys more than the currency would buy at a higher inflation rate. Borrowers want and lenders are willing to accept a lower nominal interest rate when there is less inflation. So nominal interest rates are lower.

Conversely, when expected inflation increases, borrowers are willing to pay a higher nominal interest rate because the currency used to repay is less valuable than it would be with a lower inflation rate. Likewise, lenders will require a higher rate because the currency they receive when the loan is repaid buys fewer goods and services. As a result, nominal interest rates increase when expected inflation increases.

What will happen to the cost of government borrowing in the U.S. if President Trump gets his way? A decrease in the Fed’s policy rate — the interest rate on excess reserves — will be associated with lower nominal interest rates on other interest-bearing assets and lower expected inflation. At least over time, actual inflation will fall. The U.S. government will pay fewer dollars on newly issued debt. But those dollars will be worth more in terms of what they can buy. Taxpayers will provide fewer dollars to make the interest payments on newly issued debt. But those fewer dollars will be a sacrifice of about the same amount of goods and services as the larger number of dollars with more inflation. In other words, the real interest cost on newly issued debt will be largely unaffected and taxpayers will not be any better off.

Although lower inflation will not affect the real cost of newly issued debt, it will affect the real cost of any previously issued debt outstanding. As anyone who has experienced substantial increases in inflation knows, an unanticipated increase in inflation is good for borrowers and bad for lenders because the borrower makes the previously agreed-upon interest payments in dollars that are worth less. The converse is also true: an unanticipated decrease in inflation is bad for borrowers and good for lenders because the borrower makes the previously agreed-upon interest payments in dollars that are worth more.

The federal government is a big borrower. The U.S. public debt outstanding was $16.7 trillion on September 11, 2019. Some of the debt is short term and can be refinanced at lower interest rates quickly. Some debt will remain outstanding for years and even decades. With lower inflation, the promised interest payments on debt that is not refinanced are more expensive in terms of goods and services.

In short, if President Trump wants to lower the real cost of government debt, he should urge the Federal Reserve to increase nominal interest rates — not decrease them. By reducing inflation, lower and especially negative nominal interest rates increase the real cost of government debt outstanding, leaving taxpayers with a bigger tax bill in real terms.


Gerald P. Dwyer


Gerald P. Dwyer is a Professor and BB&T Scholar at Clemson University. From 1997 to 2012, he served as Director of the Center for Financial Innovation and Stability and Vice President at the Federal Reserve Bank of Atlanta. Dwyer’s research has appeared in leading economics and finance journals, as well as publications by the Federal Reserve Banks of Atlanta and St. Louis. He serves on the editorial boards of the Journal of Financial Stability, Economic Inquiry, and Finance Research Letters. He is a past President and member of the Executive Committee of the Association of Private Enterprise Education. He is also a founding member of the Society for Nonlinear Dynamics and Econometrics, an organization for which he served as President and Treasurer.

Dwyer earned his Ph.D. in Economics at the University of Chicago, his M.A. in Economics at the University of Tennessee, and his B.B.A. in Business, Government, and Society at the University of Washington.

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