If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal


Link to pbs.org page for “Wolverine: Chasing the Phantom”

In “The Swiss National Bank Means Business with Its Negative Rates,” I wrote

There is a world of difference between a central bank that cuts some of its interest rates, but keeps its paper currency interest rate at zero and a central bank that cuts all of its interest rates, including the paper currency interest rate. If a central bank cuts all of its interest rates, including that paper rate, negative interest rates are a much fiercer animal.

At the top, I have tried to make this metaphor even more vivid with a still from a wonderful PBS documentary “Wolverine: Chasing the Phantom.” Wolverines, the mascot of the University of Michigan, are animals designed for snow and ice, and as tough as they come. The economic winter the world is struggling to get out of calls for an economic policy as tough as the wolverine.

Current negative interest rate policies lower other electronic interest rates while keeping the paper currency interest rate constant at zero. This incomplete policy of lowering some short-term interest rates under the central banks control while leaving another–the paper currency interest rate–fixed, causes predictable problems. In particular, not lowering the paper currency interest rate is hard on banks, since banks then have to worry that customers will pull money out of the bank as cash if the bank imposes a negative deposit rate. Storing large amounts of cash may be difficult and costly, but households can easily store modest amounts of cash at home instead of leaving that money in the bank. This strain on banks can be avoided by lowering the paper currency interest rate as well. For the mechanics of how to lower the paper currency interest rate, see “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.” 

That said, the current worries about the effect of negative interest rates on bank profits seem to be overblown. As an example of those worried, consider this from Jon Hilsenrath’s February 11, 2016 Wall Street Journal article “Yellen Says Fed Should Be Prepared to Use Negative Rates if Needed”:

Ms. Yellen was greeted with widespread skepticism, particularly among Republicans. Negative rates would “crush net interest margins for banks,” said Sen. Pat Toomey (R-Pa.) “It would put the us deep in the midst of a global currency war.”

“The Fed really has no real ammunition left,” said Sen. Bob Corker, (R-Tenn.)

Let me deal with each point in turn. 

Will Negative Rates Crush Bank Profits? The first is Pat Toomey’s claim that negative rates will “crush net interest margins for banks.” In addition to what I said above about cutting the paper currency interest rate in tandem with other rates to help preserve bank margins, let me say:

  1. It is likely that central banks will, in the future, effectively provide subsidies to private banks to defray the cost of provide above-market zero interest rates to small accounts, as I discuss in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies
  2. In Switzerland, Denmark, Sweden and the eurozone, there has been relatively little problem in passing on negative interest rates to commercial accounts and large accounts.
  3. Deeper negative rates would lead to quicker recovery of the world economy, which would be a big help to bank profits. It is much better for banks to have -3% for one year, than -0.3% for many, many years, particularly since -3% would be dramatic enough that they could easily explain to their customers the need for some pass-through of those negative rates.

Will Negative Rates Put Us Deep in the Midst of a Global Currency War? Interest rate cuts do indeed have an effect on exchanges rates, but that doesn’t make it a “global currency war.” The essence of a “war” is that it is zero-sum or negative sum: what I get, you lose, with some extra destruction along the way. That is not the way interest rate cuts work. If all countries cut their interest rates, that is a global monetary expansion and stimulates the whole world economy. If the world economy needs stimulus, that is a good thing–hardly what the phrase “global currency war” seems to suggest. So this is a very misleading phrase–totally inappropriate to the reality of what is happening. 

It is possible to have a global currency war. Cutting rates just isn’t it. The way to have a global currency war is for each country to sell its own Treasury bills to get funds to buy other countries’ Treasury bills. This is often called a currency intervention. If all countries do this, it is easy to see that everything cancels out and nothing is accomplished. You sell yours to buy mine, I sell mine to buy yours, and we are back at the starting block.

So selling one’s own Treasury bills to buy the Treasury bills of other countries is a zero sum endeavor and qualifies as an opening shot in a currency war. The way to avoid a global currency war of this type is to insist that central banks actually cut interest rates if they want to stimulate their economies, instead of just buying safe short-term foreign assets.

Have Central Banks Run Out of Ammunition? No. Not if they stand ready to cut the paper currency interest rate as well as other interest rates.