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Ben Bernake said today that he can't lower interest rates further because they can't be lowered below zero. IIUC benchmark interest rates are determined by what someone is willing to pay in an auction for a Treasury bond with a predetermined maturity value. When the Fed wants to lower rates it bids in these auctions with new money created electronically. Why can't the Fed simply bid more than the bond's maturity value to lower interest rates below zero?

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Why would anyone sell something for less than promised value? If the value is guaranteed to be X - why would anyone sell for X-Y%? –  littleadv Mar 1 '12 at 1:19
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Because in practice it's not easy to store money securely under a mattress and you have to put your money somewhere? –  dsimcha Mar 1 '12 at 1:29
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If zero isn't low enough, why would say -2% do anything? Even a zero % mortgage would have a payment of principal and risk the house value drops. Businesses don't have demand requiring expansion. So cheap money isn't creating any activity, even cheaper money isn't likely to either. I can borrow all I want at 2.5%, but have no desire to do so. –  JoeTaxpayer Mar 1 '12 at 3:32
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Are two different interest rates being mixed up here? The Treasury pays bond-holders interest at the stated rate, and so a negative rate (say -1% annum) would mean the bond-holder would (a) pay the Treasury $10K (say) for a five-year bond, (b) pay $100 interest to the Treasury each year in interest, (c) redeem the bond after five years and get back $10K. I think Bernanke was referring to the prime rate or interbank loan rate which determines the interest rate charged to businesses. "You want $30M for a start-up? Here is a loan and we will send you additional checks as interest each year." –  Dilip Sarwate Mar 1 '12 at 19:35
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This is "personal" finance? I would have assumed this would have been economics.stackexchange.com! –  Affable Geek Mar 1 '12 at 19:47
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4 Answers

Because giving someone a loan and paying them to take it isn't a loan anymore.

I'll grant you, some of the treasury bill auctions did slip below 0% -- people paid in slightly more than what the bill would pay out. In as much as this was done by actual investors (and not afore-mentioned helicopter Ben Bernanke keeping the printing presses running hot all night), it was major accounts fearful of the euro disintegrating and banks crashing, and so on, and needing a safe spot to stick their cash for a couple months.

Where the Fed is concerned, that interest rate he's referring to is lending they do to banks. So, how much would you take if you ran a bank and the Fed offered to pay you to take their money? A billion? A trillion? As much as you could cram in your vaults, shove in your pockets, and stuff down your favorite teller's blouse? Yea, me too.

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+1. Even at near-zero interest rates, banks can make nontrivial amounts of money by borrowing from the Fed and investing in low-risk securities, like Treasury bonds, thus keeping USA borrowing costs low. If the interest rates were less than zero, then there may be less incentive to take any risk at all; instead of borrowing at 0% and buying 2%-yield 10-year notes, for instance, borrow 4 times as much at -0.5% and stuff it in a mattress. Less risk of capital loss with the same rate of return for the bank, but there's no net benefit to the overall economy, so the Fed woouldn't do it. –  Jason R Mar 1 '12 at 14:18
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+1 more for the blouse :) –  poolie Mar 2 '12 at 0:23
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Keep in mind that the Federal Reserve Chairman needs to be very careful with his use of words.

Here's what he said:

It is arguable that interest rates are too high, that they are being constrained by the fact that interest rates can't go below zero. We have an economy where demand falls far short of the capacity of the economy to produce. We have an economy where the amount of investment in durable goods spending is far less than the capacity of the economy to produce. That suggests that interest rates in some sense should be lower rather than higher. We can't make interest rates lower, of course. (They) only can go down to zero. And again I would argue that a healthy economy with good returns is the best way to get returns to savers.

So what does that mean?

When he says that "we can't make interest rates lower", that doesn't mean that it isn't possible. He's saying that our demand for goods is lower than our ability to produce them. Negative interest would actually make that problem worse -- if I know that things will cost less in a month, I'm not going to buy anything.

The Fed is incentivizing spending by lowering the cost of capital to zero. By continuing this policy, they are eventually going to bring on inflation, which will reduce the value of the currency -- which gives people and companies that are sitting on money an dis-incentive to continue hoarding it.

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I buy things because I need them or want them not because there is inflation. Inflation isn't much of a factor for me in making purchasing decisions otherwise I would never buy electronics. If inflation is viewed as an incentive for the consumer to buy then it must also be viewed as a dis-incentive for the producer not to sell since he knows he'll be able to sell it for more next month. –  Muro Mar 2 '12 at 0:09
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Why can't the Fed simply bid more than the bond's maturity value to lower interest rates below zero?

The FED could do this but then it would have to buy all the bonds in the market since all other market participants would not be willing to lend money to the government only to receive less money back in the future. Not everyone has the ability to print unlimited amounts of dollars :)

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If the Federal Reserve were to pay banks to hold money, they would need to get the money from somewhere to do so. They would have three options:

  1. Go to Congress, and request and authorization of funds.
    As an quasi-independent entity, however, it would be both highly unorthodox for an institution to diminish its own authority by requesting funding, and politically difficult for the Congress to appropriate it.

  2. Transfer held-assets After QE & QE2, the Fed is now the holder of several assets (mortgages and the like) that are already unorthodox for it to hold. It acquired these assets in the first place to soak up excess demand. If these assets were transferred back to banks, it would have exactly the opposite effect - increasing supply and further suppressing the value of the assets they would be trying to shore up by lowering the interest rate.

  3. "Print money" The fed could raise the money supply by issuing new bonds. This is inherently inflationary, and while pretty much everyone agrees this isn't bad in the short run, there is already widespread fear that in the long run, QE by itself is going to unleash massive inflation once growth returns anyway. To keep "pushing on this string" would only excerabate these fears, and quite likely turn it into a self-fufilling prophecy.

In short, the Fed "could" pay banks to hold money, but the political and economic consequences of raising the needed funds to do so would all undermine the institution or the desired effect.

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