Negative Rates Are A Policy Mistake
February 24, 2016
Negative interest rates will destroy the banking sector. They undermine bank profitability and create a distrust among depositors. Negative savings rates will not revitalize aggregate demand, but rather curtail it, and will ensure continued under-investment in the economies that adopt them. Days after Japan unexpectedly adopted negative rates, Janet Yellen testified in front of Congress, and re-opened the possibility of negative rates in the United States. If pursued, it would be unprecedented in the U.S. and a colossal mistake.
The justification for negative rates goes something like this: Commercial banks are sitting on a massive amount of excess reserves currently deposited at central banks. Negative interest rates on these deposits will incentivize commercial banks to initiate more loans. As banks make more loans they become more profitable because they are paying less interest on excess reserves, and earning more interest on their growing loan book. This increases bank profitability and spurs growth for the overall economy.
This seemingly logical progression is a fallacy. In economies where Quantitative Easing exists, like Japan, excess reserves will continue to grow regardless of how much banks lend. This is due to the very nature of money creation. When assets are purchased by a Central Bank (quantitative easing), funds are credited to the selling bank’s excess reserve account. This is the process by which money is created–out of thin air. That money cannot leave the system, until the Central Bank sells an asset and debits a bank’s excess reserve account. While it is possible for a single bank to decrease its excess reserves by initiating a loan, that loan inevitably becomes a deposit for the borrower at another bank, ultimately resurfacing again as excess reserves. Todd Keister and James McAndrews, research economists at the New York Federal Reserve, adeptly describe this dynamic in their 2009 paper entitled, “Why Are Banks Holding So Many Excess Reserves?” Their conclusion–that the amount of excess reserves is determined by the magnitude of the Fed’s asset purchases–has important implications for Central Banks that are considering implementing negative reserve rates in conjunction with asset purchases. The combination of these two policy initiatives is paradoxical in nature. Negative rates on excess reserves punish member banks for a problem that they did not cause nor are they in a position to fix. The outcome will be a collapse of net interest margins, and destruction of profitability in the banking sector. Mix QE and negative rates and you have a recipe for disaster.
In economies not engaged in quantitative easing, like the U.S., negative rates will also pressure banking profitability. Interest revenue for banks recalibrates lower as interest rates fall since all lending is based off of the “risk free” rate. Typically, banks can lower their interest expense paid on deposits faster than the fall in their interest revenue. As a result, their net interest margins actually increase during periods of falling rates. However, this only functions until rates hit zero. At that point, there is no room for banks to lower interest expense, and net interest margins begin to fall. This occurred post-recession in the United States: Net interest margins increased during 2009 and 2010 only to subsequently fall as maturing loans were reinvested at lower rates and interest expenses remained constant–near zero. Implementing negative interest rates will only exacerbate this process.
If Banks choose to pass negative interest rates onto depositors, so as to salvage the meager net interest margins that remain, the consequences will likely be more severe. Since the Great Recession, depositors have been content leaving their savings at banks despite shrinking returns. Still, there is a marked difference between not making money and losing money on savings. If deposit rates fall below zero, the economy would run the risk of depositors withdrawing their funds en masse. There would be an opportunity cost to not having one’s money under the mattress. This is a risk the Federal Reserve cannot afford to take.
Monetary intervention is important in the modern economy, but it should be limited to its original intention—to repair monetary imbalances due to the bi-polarity of financial markets. When money supply cannot satisfy demand, Central Banks should provide the necessary liquidity. When supply grows too fast causing inflation, they should remove liquidity. Unfortunately, monetary policy is in danger of morphing into a tool that seeks to increase aggregate demand and negative interest rates embody this transition. If companies and individuals do not feel comfortable taking out a loan, or spending money, central banks are going to make it so painful to save money that they will force them to borrow and spend. Central Banks have no business making these decisions on behalf of their citizens.
Negative interest rates are a policy mistake, and the Federal Reserve should reject them as a plausible solution. At best, they stress bank profitability. At worst, banks pass negative rates onto depositors resulting in a wave of withdrawals that threaten the banking system. The Federal Reserve should allow deficiencies of aggregate demand to be solved by fiscal policy initiatives and instead focus only on balancing monetary supply and demand.
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