Fed tightening, asymmetric risks, and possibility of negative rates.

A quick comment on this thoughtful post by the great JP Koning, whose posts on monetary econ and finance have become regular reading for me since I found him on the internet.

JP makes the point that the possibility that rates could now safely go negative changes the calculation in the Fed's mind, eliminating one particular concern that might prevent it from raising.  The concern, articulated by many, Krugman and others, is that if a rise proves to be the wrong choice, there is insufficient room to reverse course and cut to counter the ensuing slowdown.  Clearly, if rates can go negative, then there is more room to cut.

However, although rates have gone negative, it's clearly the case that there is still a lower bound to rates.  In our standard model this will be equal to the marginal cost of managing cash.  In real life it will be connected with the same, real life counterparts.  If you think about the size of historical cycles in interest rates, [adjusting for the slow run changes in inflation regimes that have gone on], the Fed might want, in an ideal world, to be able to raise rates to say 10%, and cut them to -8%.  [I recall discussions at central bank conferences that -8% was a typical estimate of the amount of missing stimulus in 2009].  Say, at the outside, market rates could be tempted down to -1.25%.  That's still a lot of missing stimulus to generate asymmetry in the risk calculation the Fed makes.

The story isn't quite as stark as I have painted it, because there is the possibility of doing more quantitative or credit easing.  But i) there are still controversies about just how effective that might be and ii) there may well be political constraints on growing the Fed balance sheet even further from its current swollen state.

We might well also wonder whether a correction in rates following a mistaken rise would really need to be so large as to use up all the missing stimulus that the Fed was deprived of in the early stages of the financial crisis.  Surely this would not be another Lehman's moment? Surely this time would be different [more moderate]?  Well, probably.  But then rates are starting out much lower to begin with.  So there does not need to be anything like another Lehman's moment to push the desired Fed rate well below even -1.5%.