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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.
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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
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