The New Frontier of Negative Interest Rates
When central banks start exploring strange new worlds, the results aren't always ideal.
Quantitative easing wasn't just a change in monetary policy, but a whole new kind of monetary policy -- a journey into the unknown. It isn't over yet, but there's already a debate about drawbacks and unintended consequences. With that question far from resolved, another adventure in super-loose monetary policy has begun: negative interest rates. This week, as global markets plunged, unforeseen complications have arisen there too.
Shares in European banks suffered especially badly during this renewed market turmoil. There was more than one reason, but negative rates seem to be implicated. Banks' deposits at the European Central Bank now pay minus 0.3 percent, and a further cut has been advertised for next month. The idea is to encourage banks to lend more (rather than sit on idle balances) and to lower the cost of capital for riskier borrowers. The new concern is that negative rates have squeezed banks' profits and put their soundness in question.
Advocates of negative rates might be perplexed by this apparent squeeze on bank profits. They might wonder, why should that happen? Banks simply have to pass the negative rate on to their various customers, borrowers on one side and lenders on the other. The spread between the two needn't change. But it seems that banks have been reluctant to force negative rates on to their depositors -- hence the squeeze on profits. Perhaps the banks are worried that depositors wouldn't like it. Upsetting them is something banks are understandably reluctant to do.
Policy makers seem to have doubts as well. The Bank of Japan recently startled financial markets by adopting negative rates, having previously said it wasn't going to -- but it structured the new policy so that it works at the margin of the banks' balances with the central bank, rather than applying to the total. Why? So that the banks wouldn't need to pass the change through to depositors.
Policy makers and banks alike are embracing negative rates timidly -- and they're right to be cautious. Substantially negative rates would be an even braver adventure than QE.
As I've previously mentioned, a world of negative rates is a very weird place -- one where savers pay borrowers for the privilege of deferring consumption, and borrowers get compensated for bringing spending forward. An editorial in The Economist made the point well:
Small savers would use any available form of prepayment—gift vouchers, long-term subscriptions, urban-transport cards or mobile-phone SIM cards—to avoid the cost of having money in the bank.
That would be only the start of the topsy-turviness. Were interest rates negative enough for long enough, specialist security firms would emerge that would build vaults to store cash on behalf of big depositors and clear transfers between their customers’ accounts. Firms would seek to make payments quickly and receive them slowly. Tax offices would discourage prompt settlement or overpayment of accounts: one Swiss canton has already stopped discounts for early tax payment and said it wants to receive money as late as possible.
Well, that last part sounds quite appealing. (Everybody's favorite New Yorker cartoon comes to mind: "How about never? Is never good for you?") People would adjust to the new rules, eventually. Trouble is, that calls into question the policy's usual rationale: It's typically seen as a temporary expedient.
Concerning the flight to cash, that could be dealt with as well. To remind, with negative rates in place, cash is a better place for savings than a bank account. The possibility that people might switch to cash therefore makes it difficult to force rates below zero. The cost of holding cash (including the risk that it might be stolen) creates some room for maneuver. Beyond this, central banks could further discourage the use of cash by forcing down its value relative to electronic balances -- in effect, taxing its use -- or move to abolish it altogether.
Undermining paper currency in this way would be politically fraught, at best. Yes, inflation undermines paper currency, so the phenomenon is hardly new. But no central bank will want to say, "We can't get inflation any higher with our usual methods so we've decided to undermine the currency directly."
Suppose they did dare, thinking they could get away with it and reckoning that the economics is correct even if the politics is, you know, challenging. With financial anxiety running high and the flow of credit blocked, would such a dramatic departure actually work as intended, helping to calm nerves and incline borrowers and lenders to take risks? It might very well do the opposite. A reckless-seeming experiment is not the best way to restore confidence.
Central banks have shown that the lower bound for interest rates is less than zero. They've shown that the ability to hold cash instead of electronic balances doesn’t draw any sharp or fixed line, as previously supposed. There's at least some room for maneuver at less than nothing.
The European Central Bank can probably make its deposit rate a bit more negative. In fact, it's as good as promised to do so in March. Legal complications permitting, the U.S. Federal Reserve could push rates slightly negative as well, though Fed Chair Janet Yellen told Congress this week she thought it wouldn't be necessary.
The main point, though, is that this room for maneuver is limited. There is indeed a lower bound to interest rates -- cultural, political, prudential -- and we're close. For the moment, we just don't know how close.
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