Should the wingpsan of a hawk equal the wingspan of a dove?

Janet Yellen is in a tough spot.

The US Federal Reserve chair presides over a country in pretty good economic health. Unemployment is just 5.3 per cent. But even though the official interest rate is zero (technically 0 to 0.25 per cent), there is huge pressure to not raise that official interest rate.

Commentators are right to be cautious. There is plenty of evidence supporting being very cautious about raising rates.

Both Australia and New Zealand lifted interest rates from their GFC lows swiftly. Australia did so in 2009, NZ twice in 2011 and 2014. Both countries dropped rates again soon afterwards, as these graphs show, .

Screen Shot 2015-10-17 at 12.07.33 pm Being hasty in raising rates is unwise.  So Yellen’s cautious stance is probably appropriate.

But her position is especially difficult because her options are so limited. US rate changes, by convention, happen in lumps of 0.25 percentage points. Just like Australia’s and New Zealand’s.

She faces, by convention, a binary choice. Leave rates steady, or execute a 0.25 point hike that could frighten markets.

A quarter of a percentage point probably appeared vanishingly small back in those dimly remembered normal times, when interest rates were so much higher. But now a quarter of a percentage point looks like quite a hurdle.

The size of a standard rate move now raises questions.

A key one that nobody seems to be contemplating: Should rate rises be the same size as rate cuts? The obvious answer is no.

Economies tank hard.  Recoveries are slower and more tentative. Unemployment rises steeply, but it falls slowly, as this next graph shows.

Recessions send unemployment spiking. And so can low growth.

There is an implicit understanding that rate cuts can be bigger than hikes. The Australian government bundles groups of 0.25 together when things go bad particularly quickly. For example the RBA made a cut of 0.50 in 2012, and three cuts of 1.0 in late 2008 and early 2009.

But there is no explicit understanding that rate cuts could be smaller than 0.25 when they are rising.

Why? There is no apparent technical impediment to this.

Australia is now perfectly capable at holding rates at levels more tightly defined than 0.25 per cent intervals, as this graph of the target (red) and actual (black) rate shows:

Screen Shot 2015-10-17 at 12.27.37 pm

Whether Yellen should raise rates is a divisive issue. She can counter that political division with a bit of  arithmetic division.

Splitting her first hike into several small pieces is the answer.  Rises of 0.1 per cent – or even smaller – could be just the trick at difficult times like this.

Negative interest rates on deposits just got announced in Europe. Here’s how that works.

In Europe, something wild and new and kind of dangerous is happening. They’ve put negative interest rates on deposits.

Imagine putting your money in the bank, and getting a negative interest rate. You’d want to get it out again as soon as possible, right? That’s the point.

Interest rates are used to control activity in the economy. I wrote about this a few months ago: “I know the RBA sets interest rates but I’m embarrassed to ask why. An explainer.

If the interest rate is negative, the central bank is goading you into using your money, not just sitting on it. That should mean more spending. More spending makes more jobs. And like this they hope to get Europe out of the quicksand of high unemployment.

So, if this works, how come it’s never been tried before?

The thing is, interest rates don’t just work on their own. You’ve got to consider inflation. If you get 2 per cent interest on your deposit but inflation is 3 per cent, then really you are losing the purchasing power of your money. (in the business this is called “negative real interest rates” where the word “real” means inflation is taken into account).

You can make “negative real interest rates” by setting the interest rate below inflation. That’s easy. The problem in Europe is there’s so little activity that inflation is very, very low. They have to make the advertised interest rate negative to get the “real” interest rate negative.

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Source: WSJ

Now, it’s worth noting that the negative interest rates don’t apply to the average punter. They are for the deposits that banks have with the central bank. (Millions and billions of euros every night).

The reason for that is simple.  If you or I see that the $11.50 we have in the bank is attracting a negative interest rate (here I am ignoring the “real” interest rate), there’s a simple trick we can use – take it out of the bank and turn it into cash. Cash gets an interest rate of zero, so that’s a lot better than leaving your money in the bank.

But guess what? There’s talk in some economic circles about getting rid of cash so negative interest rates can apply to  normal people too. It’s not coming from freaky fringe dwellers either, but mainstream people with Nobel Prizes and a lot of clout.

If you only have your money in electronic form, there’s no way to avoid keeping it in a bank account. You can’t put 1s and 0s in a shoebox under your bed.

Negative interest rates would not necessarily cause a riot. Bank fees already work in such a way that we’re used to seeing our bank balances retreat when left alone. A cash free future is plausible. People are using cash less and less.

the decline and fall of cash
Cash use falls sharply in all age groups. (Source: RBA)

While the rise of Paypass could end up stranding us in a future where we actually pay banks to hang onto our money instead of the other way around, there are other innovations that make a cashless society with negative interest rates unlikely.

I am talking about Bitcoin. The rise of a kind of cash that is beyond the control of central banks means attempts to control rates on government-issued cash are more futile than in the past.

For now, here’s hoping that rates of -0.1 per cent can help reduce joblessness in Europe, where youth unemployment is a very frightening 23 per cent.