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Negative interest rate and monetary policy By-Abdullah A Dewan The Financial Express, 08 Sept 2012 Academic and US Federal Reserve Bank (Fed) economists are promoting the idea why negative interest would be a potent tool to stimulate the slow growing economy. Although, the Fed's aggressive purchase of long-term government bonds (Treasuries) from banks through QE-1 and QE-2 (QE: Quantitative Easing) succeeded in pushing the long-term interest rates -- specially the mortgage rate -- at their historic lows, the economy failed to pick up the desired steam (last quarter growth : 1.94 per cent) while the unemployment rate remaining over 8.0 per cent. As we know, nominal interest rate (NIR) has two components: real interest rate (RIR) plus the expected inflation rate (EIR). That is, NIR = RIR + EIR. If people's expectations of inflation accelerate, then real rates can be negative: RIR = NIR- EIR. The interest rates on any bank's loans and people's deposits in banks are nominal rates. Having negative real rate is the most common experience unlike the nominal rate which is normally positive but at times can be negative too. A negative nominal rate implies that depositors will pay a fee to put their money in banks in whatever form they choose instead of receiving interest on them. Alternatively, a negative interest on loans would imply banks will pay borrowers some fees to take loans from banks. Obviously, profit-seeking banks will not lend below 0 per cent interest as that will guarantee a loss, and a bank offering a negative interest on deposit will find few depositors as savers will instead hold cash. However, interest paid by central banks (CB) against holding banks excess can be negative. For example in July 2009 Sweden's Riksbank was the first CB to use negative interest rates — lowering its deposit rate to -25 bps or — 0.25 per cent (100 bps = 1.0 per cent). This is possible because Swedish banks do not have the option to hold cash. They must hold their reserves with the central bank. Other examples of negative interest rate experience include countries such as Switzerland, Denmark, Germany, Finland, the Netherlands and Austria, which sold government bonds at negative yields. One obvious reason why would people invest in bonds with negative yields is safety and protection of their wealth against the eurozone breaking up. In the US, banks are currently paid 25 bps to keep excess reserves (also called reserve money) in their Fed account. Even though 0.25 per cent interest seems meager, banks nonetheless find it an attractive alternative to investing in short-term Treasuries which pay much less (example: 1, 3, 6 and 12 months Treasury bills yield 10, 10, 14 and 16 bps respectively). Banks have parked approximately $1.5 trillion of excess reserves at the Fed (interest received = $3.75billion). The benefit of keeping reserves with the Fed is almost like having cash in the bank's vault - only a click on the key board away — eliminating liquidity constraints. The Fed unloaded these reserves to the banking system through successive QEs to stimulate the economy. However, banks have been reluctant lenders since the financial crisis that began in the late 2007. The Fed is still exploring all possible policy options to push banks to engage in lending activities. Imposing negative interest rate on banks reserves at the Fed is one such option. "I'm becoming more sympathetic" to the idea — a new avenue of monetary policy stimulus could involve the Fed moving into "negative territory," opined the St Louis Fed President James Bullard Bullard. From the current level of 25 bps to 0, "you could go to minus 25 or minus 50 bps. That gives it more punch than simply cutting the level to zero", he added. He further said that if negative rates were put in place, "it would definitely change the calculus for the banks." The Fed's payment of interest on banks' reserves may have lessened banks' drives to lend or use them for other uses. Prior to 2008, there was no provision for the Fed to pay interest against holding banks reserves. Fed gained the power to pay interest in October 2008 primarily to contain the inflationary aspects of its balance sheet. If these reserves become a source of brewing inflationary pressure, the Fed can raise the interest rate it pays as an incentive to banks to keep their reserve money sidelined instead of lending to fuel inflation. There is a growing feeling that the Fed Chairman Ben Bernanke will respond to the weak economy with some form of new monetary stimulus. It could be QE-3 or negative interest rate policy. Former Fed Vice-Chairman Alan Blinder has been urging on the Fed for more than two years now to cut the interest rate it pays on banks reserves as a way of discouraging banks from holding them at the Fed and instead find other uses such as expanding loans or invest in the capital markets. Blinder recommends proceeding in stages: First slash the interest on excess reserves (IOER) to zero. In the event no change in banks behavior, cut the rate to say, -25 bps - which implies charging a fee to banks for holding their reserves at the Fed. Blinder argues, "Doing so would provide a powerful incentive for banks to disgorge some of their idle reserves. True, most of the money would probably find its way into short-term money-market instruments such as fed funds, T-bills and commercial paper. But some would probably flow into increased lending, which is just what the economy needs." The Fed has so far argued against negative IOER arguing that it may not be a powerful instrument. Besides the Fed thinks that zero or negative IOER would drive the other money-market rates even closer to zero than they're - "hurting money-market funds and otherwise impeding the functioning of money markets". If the Fed imposes a negative interest rate policy, it won't be the first. For example, the European Central Bank (ECB) recently cut IOER to zero. Denmark's National Bank took a more drastic move - cutting its deposit rate to minus 20 bps. So far no adverse fallout has sprouted. ii Blinder argues, "If the Fed makes holding reserves more attractive, banks will hold more of them. Why doesn't the same reasoning apply in the other direction?" What if the IOER is slashed from +25 bps to -25 bps and banks still remained passive - no new loans are created? This move is still worth taking as Blinder argues - saves the Fed $3.75 billion interest a year and an equal amount will accrue from charging fees to banks — a $7.50 billion swing from banks to taxpayers. The financial crisis that caused the American economy plunge into the Great Recession in 2008 — and still recovering — forced the Fed to innovate non-traditional monetary policies: Providing liquidities by buying banks subprime mortgage backed securities; quantitative easing (buying long-term Treasuries), and operation twist (selling shortterm T-bills to buy equal dollar amount of long-term Treasuries) to bring down longterm interest rate, These instruments certainly stabilized the financial markets even though output and employment growth remained inimical. Banks - instead of expanding loans — held a massive amount of excess reserves ($1.5 trillion) sidelined. The growing arguments in favor of imposing the "negative interest rate policy" are increasingly becoming a reality. The author received his PhD in economics and was formerly a Physicist and Nuclear Engineer at BAEC. He is a Senior Fellow at the Policy Research Institute, Dhaka and Professor of Economics at Eastern Michigan University, USA iii