Tag: negative interest rates

In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.

The two articles below argue that the failure has been due to a flawed model of monetary policy: one that takes too little account of the behaviour of banks and the drivers of consumption and of physical investment. Negative interest rates on banks’ holdings of reserves in central banks are hardly likely to push down lending rates to businesses sufficiently to stimulate investment in new plant and machinery if firms already have overcapacity. And consumers are unlikely to borrow more for consumption if their wages are barely rising and they already have debts that they fear will be difficulty to pay off.

As Joseph Stiglitz points out:

As real interest rates have fallen, business investment has stagnated. According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in both Europe and the US in recent years. (In the US, it fell from 8.4% in 2000 to 6.8% in 2014; in the EU, it fell from 7.5% to 5.7% over the same period.) Other data provide a similar picture.

And the unwillingness of many firms and individuals to borrow is matched by banks’ caution about lending in an uncertain economic environment. Many are more concerned about building their capital and liquidity ratios to protect themselves. In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less

What central banks should be doing, argue both Stiglitz and Elliott, is finding ways of directly stimulating consumption and investment. Perhaps this will involve central banks “focusing on the flow of credit, which means restoring and maintaining local banks’ ability and willingness to lend to SMEs.” Perhaps it will mean using helicopter money, as we examined in the previous blog. As Larry Elliott points out:

The fact that economists at Deutsche Bank published a helpful cut-out-and-keep guide to helicopter money last week is a straw in the wind.

As the Deutsche research makes clear, the most basic variant of helicopter money involves a central bank creating money so that it can be handed to the finance ministry to spend on tax cuts or higher public spending. There are two differences with QE. The cash goes directly to firms and individuals rather than being channelled through banks, and there is no intention of the central bank ever getting it back.

So if the model of monetary policy is indeed flawed, prepare for more unconventional measures

Articles

What’s Wrong With Negative Rates?, Project Syndicate, Joseph Stiglitz (13/4/16)
The bad smell hovering over the global economy The Guardian, Larry Elliott (17/4/16)

Questions

  1. What arguments does Stiglitz use to support his claim that the model of monetary policy currently being used is flawed?
  2. In what ways has monetary policy hurt older people and what has been the effect on their spending and on aggregate demand in general?
  3. Why has monetary policy encouraged investors to shift their portfolios toward riskier assets?
  4. Examine the argument that ultra-low interest rates may result in a rise in unemployment in the long term by affecting the relative prices of capital and labour.
  5. What forms might helicopter money take?
  6. Would the use of helicopter money necessarily result in an increase in aggregate demand? What would determine the size of any such increase?

In the blog Japan’s interesting monetary policy as deflation fears grow we detailed the aggressive monetary measures of Japan’s central bank to prevent a deflationary mindset becoming again established. In January it introduced a negative interest rate on some deposits placed with it by commercial banks. This is in addition to it massive quantitative easing programme to boost the country’s money supply. Despite this, the latest consumer price inflation data show inflation now running at zero per cent.

As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation (click here to download a PowerPoint file of the chart). In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, through purchases of government bonds from investors.

Following this substantial monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.

However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. The latest inflation data show that the annual rate of CPI inflation in January 2016 fell to zero percent. In other words, consumer prices were on average at the levels seen in January 2015.

The latest inflation numbers appear give further credence to the fear of the Bank of Japan that deflation is set to return. The introduction of a negative deposit rate was the latest move to prevent deflation. As well as encouraging banks to lend, the move is intended to affect expectations of inflation. By adopting such an aggressive monetary stance the central bank is looking to prevent a deflationary mindset becoming re-established. Hence, by increasing the expectations of the inflation rate and by raising wage demands the inflation rate will rise.

The loosening of monetary policy through a negative interest rate follows the acceleration of the quantitative easing programme announced in October 2015 to conduct Open Market Operations so as to increase the monetary base annually by ¥80 trillion.

The decline of Japan’s inflation rate to zero may yet mean that further monetary loosening might be called for. Eradicating a deflationary mindset is proving incredibly difficult. Where next for Japan’s monetary authorities?

Data

Consumer Price Index Statistics Bureau of Japan

New Articles
Japan’s inflation drops to zero in January MarketWatch, Takashi Nakamichi (25/2/16)
Japan inflation falls back to zero in January: govt AFP (26/2/16)
With pause in inflation, many brace for retreat Nikkei Asian Review (27/2/16)
Japan’s inflation rate has fallen again – to 0% Business Insider Australia, David Scutt (26/2/16)

Previous Articles
Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates The Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory The Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)

Questions

  1. What is deflation?
  2. What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
  3. To what extent are national policy-makers able to exert pressure over the rate of inflation?
  4. What does a negative interest rate on deposits mean for depositors?
  5. What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
  6. What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
  7. How might the negative interest rate effect how people wish to hold their wealth?

The perceived wisdom is that nominal interest rates have a lower zero bound. The Swedish central bank (the Ricksbank) has effectively been charging financial institutions to deposit money at the central bank since 2009. On 29 January 2016 the Central Bank of Japan also introduced a negative interest rate on deposits. The -0.1 per cent rate currently applies to a portion of the reserves held by financial institutions at the central bank. The move is another attempt to pump energy into a struggling economy.

As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation. In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, principally through purchases of government bonds from investors. Following the monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.

However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. Now there appears to be an increasing fear at the Bank of Japan that deflation may be set to return. The introduction of a negative deposit rate is intended to prevent deflation. In particular by affecting expectations of inflation. The hope is to prevent a deflationary mindset becoming re-established.

The further loosening of monetary policy through a negative interest rate follows on the heels of an acceleration of quantitative easing last October. Back then, the Bank of Japan said that it would conduct Open Market Operations so that the monetary base would increase annually be ¥80 trillion. This was reaffirmed in its 29 January announcement. For an economy that has experienced four recessionary contractions since 2008 and with provisional estimates suggesting that it contracted by 0.4 per cent in the final quarter of 2015, it remains to be seen whether further monetary loosening might yet be called for.

Data

Consumer Price Index Statistics Bureau of Japan

Articles

Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)

Questions

  1. What does a negative interest rate on deposits mean for depositors?
  2. What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
  3. What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
  4. How might the negative interest rate effect how people wish to hold their wealth?
  5. What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
  6. To what extent are national policy-makers able to exert pressure over the rate of inflation?

As we saw in the blog post Down down deeper and down, or a new Status Quo?, for many countries there is now a negative rate of interest on bank deposits in the central bank. In other words, banks are being charged to keep liquidity in central banks. Indeed, in some countries the central bank even provides liquidity to banks at negative rates. In other words, banks are paid to borrow!

But, by definition, holding cash (in a safe or under the mattress) pays a zero interest rate. So why would people save in a bank at negative interest rates if they could get a zero rate simply by holding cash? And why would banks not borrow money from the central bank, if borrowing rates are negative, hold it as cash and earn the interest from the central bank?

These questions are addressed in the article below from The Economist. It argues that to swap reserves for cash is costly to banks and that this cost is likely to exceed the interest they have to pay. In other words, there is not a zero bound to central bank interest rates, either for deposits or for the provision of liquidity; and this reflects rational behaviour.

But does the same apply to individuals? Would it not be rational for banks to charge customers to deposit money (a negative interest rate)? Indeed, there is already a form of negative interest rate on many current accounts; i.e. the monthly or annual charge to keep the account open. But would it also make sense for banks to offer negative interest rates on loans? In other words, would it ever make sense for banks to pay people to borrow?

Read the folowing article and then try answering the questions.

Article

Bankers v mattresses The Economist (28/11.15)

Central bank repo rates/base rates
Central banks – summary of current interest rates global-rates.com
Worldwide Central Bank Rates CentralBankRates

Questions

  1. What is a central bank’s ‘repo rate’. Is it the same as (a) its overnight lending rate; (b) its discount rate?
  2. Why are the Swedish and Swiss central banks charging negative interest rates when lending money to banks?
  3. What effect are such negative rates likely to have on (a) banks’ cash holdings; (b) banks’ lending to customers?
  4. Why are many central banks (including the ECB) charging banks to deposit money with them? Why do banks continue to make such deposits when interest rates are negative?
  5. Would banks ever lend to customers at negative rates of interest? Explain why or why not.
  6. Would banks ever offer negative rates of interest on savings accounts? Explain why or why not.
  7. How do expectations about exchange rate movements affect banks willingness to hold deposits with the central bank?
  8. What are the arguments for and against abolishing cash altogether?

If you asked virtually any banker or economist a few years ago whether negative (nominal) interest rates were possible, the answer would almost certainly be no.

Negative real interest rates have been common at many points in time – whenever the rate of inflation exceeds the nominal rate of interest. People’s debts and savings are eroded by inflation as the interest due or earned does not keep pace with rising prices.

But negative nominal rates? Surely this could never happen? It was generally believed that zero (or slightly above zero) nominal rates represented a floor – ‘a zero lower bound’.

The reasoning was that if there were negative nominal rates on borrowing, you would effectively be paid by the bank to borrow. In such a case, you might as well borrow as much as you can, as you would owe less later and could pocket the difference.

A similar argument was used with savings. If nominal rates were negative, savers might as well withdraw all their savings from bank accounts and hold them as cash (perhaps needing first to buy a safe!) Given, however, that this might be inconvenient and potentially costly, some people may be prepared to pay banks for looking after their savings.

Central bank interest rates have been hovering just above zero since the financial crisis of 2008. And now, some of the rates have turned negative (see chart above). The ECB has three official rates:

The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system.
The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem.
The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem.

The first of these is the most important rate and remains above zero – just. Since September 2014, it has been 0.05%. This rate is equivalent to the Bank of England’s Bank Rate (currently still 0.5%) and the Fed’s Federal Funds Rate (currently still between 0% and 0.25%).

The third of the ECB’s rates is currently 0.3%, but the second – the rate on overnight deposits in the ECB by banks in the eurozone – is currently –0.2%. In other words, banks have to pay the ECB for making these overnight deposits (deposits that can be continuously rolled over). The idea has been to encourage banks to lend rather than simply keeping unused liquidity.

In Nordic countries, the experiment with negative rates has gone further. With plenty of slack in the Swedish economy, negative inflation and an appreciating krona, the Swedish central bank – the Riksbank – cut its rates below zero.

Many City analysts believe that the Riksbank will continue cutting, reducing its key interest rate to minus 0.5% by the end of the year [it is currently 0.35%]. Switzerland’s is already deeper still, at minus 0.75%, while Denmark and the eurozone have joined them as members of the negative zone.

But the nominal interest rate on holding cash is, by definition, zero. If deposit rates are pushed below zero, then will more and more people hold cash instead? The hope is that negative nominal interest rates on bank accounts will encourage people to spend. It might, however, merely encourage them to hoard cash.

The article below from The Telegraph looks at some of the implications of an era of negative rates. The demand for holding cash has been increasing in many countries and, along with it, the supply of banknotes, as the chart in the article shows. Here negative interest are less effective. In Nordic countries, however, the use of cash is virtually disappearing. Here negative interest rates are likely to be more effective in boosting aggregate demand.

Article

How Sweden’s negative interest rates experiment has turned economics on its head The Telegraph, Peter Spence (27/9/15)

Data

Central bank and monetary authority websites Bank for International Settlements
Central banks – summary of current interest rates global-rates.com

Questions

  1. Distinguish between negative real and negative nominal interest rates.
  2. What is the opportunity cost of holding cash – the real or the nominal interest rate forgone by not holding it in a bank?
  3. Are there any dangers of central banks setting negative interest rates?
  4. Why may negative interest rates be more effective in Sweden than in the UK?
  5. ‘Andy Haldane, a member of the Monetary Policy Committee (MPC) … suggested that to achieve properly negative rates, the abolition of cash itself might be necessary.’ Why?
  6. Why does Switzerland have notes of SF1000 and the eurozone of €500? Should the UK have notes of £100 or even £500?
  7. Why do some banks charge zero interest rates on credit cards for a period of time to people who transfer their balances from another card? Is there any incentive for banks to cut interest rates on credit cards below zero?