Are Negative Fed rates really possible?

Harvard Economics Professor Gregory Mankiw thinks so. In this morning's New York Times, Mankiw proposes having the Federal Reserve decrease the Federal Funds rate below 0 percent. The zero bound has been considered binding because reducing it further would make potential lenders better off simply holding cash than lending. Mankiw, who is well aware of the problem of hording cash provides two unlikely solutions.

The first would be a "tax" on money. Likely by dissolving all money ending in a randomly selected serial number a year from now.  Of course such a move would require some enforcement. Someone would actually have to check serial numbers in a way that would discourages businesses from accepting the now worthless bills. Not to mention the way such a move could strain both domestic and international trust in the US dollar.

Mankiw's simpler solution is to simply have the Fed promise future inflation. He writes:

Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Yet commitments from the government are difficult to obtain and even more difficult to keep and have people trust. Mankiw mentions that Bernanke seems well equipped to make such a commitment. Bernanke’s term as chairman expires at the start of 2011. The possibility of President Obama appointing an new chairman could be enough to break faith in an inflation promise. More importantly, while inflation helps borrowers, it hurts anyone whose wages are not adjusting upward to meet the new price level. While many employees have contracts that include inflation-based cost of living adjustments, non-contract, hourly workers are likely to be negatively impacted; a situation that the Fed would be pressured to avoid.