Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates

Link to the Wikipedia article on Mark Carney

I have called Ben Bernanke a hero many times for his actions to stem the hemorrhaging of the US economy during the 2008 Financial Crisis and the ensuing Great Recession (in “Four More Years! The US Economy Needs a Third Term of Ben Bernanke,” in “Ben Bernanke on Trial” and in my presentations to central banks around the world). But for his actions as Governor of the Bank of Canada that insulated Canada from the worst of the Great Recession, and his work as Chairman of the G20′s financial stability board, Mark Carney is every bit as great a hero. Although for the sake of financial stability, it is worth desiring even higher equity requirements for banks, those equity requirements are probably significantly higher and the international financial system significantly more stable than it would be without Mark Carney’s leadership.

In addition to my assessment of Mark Carney as a hero, I have to confess myself a fan. Along with Haruhiko Kuroda, he tops my list of central bankers I would like to meet in person, but haven’t yet. And I wrote “Could the UK Be the First Country to Adopt Electronic Money?” thinking of Mark Carney’s remarkable career move from the Bank of Canada to head the Bank of England.

But I take issue with Mark Carney’s inadequate analysis of the transmission mechanism for negative interest rates in his recent speech “Redeeming an unforgiving world.” It is the sort of thing people are saying these days, but it is incomplete and misleading. One could easily come away with the idea that unless regular households face negative interest rates in their deposit accounts that negative interest rates only work through the exchange rate channel, which is zero-sum from a global point of view. What Mark Carney meant might be much more sensible: except for small household accounts, if Mark Carney’s point is simply that more pass-through of negative interest rates is better than less, I wholeheartedly agree. (Fortunately, experience with negative interest rates in Europe suggests that–with the exception of household accounts, large and small–there is a great deal of pass-through.) But in any case it is important to deal with what Mark Carney said and how it might be misconstrued. To show that I am not off-base to worry about such a construal, consider this from George Magnus in Prospect:

To their credit, policymakers did note that monetary policy alone was no longer enough to deal with the problems in the world economy. Mark Carney, Governor of the Bank of England, had earlier criticised countries pursuing Negative Interest Rate Policies, or NIRP, by arguing that where retail customers were protected from the effects, countries were essentially pursuing a covert form of currency depreciation.

Of course monetary policy is not enough to deal with all the problems of the world economy: I said as much in “Governments Can and Should Beat Bitcoin at Its Own Game”:

But make no mistake: Giving electronic money the role that undeserving paper money now holds will only tame the business cycle and end inflation. Fostering long-run economic growth, dealing with inequality, and establishing peace on a war-torn planet will remain just as challenging as they are now. But every time one set of problems is solved, it allows us to focus our attention more clearly on the remaining problems. It is time to step up to that next level.

Monetary policy cannot solve all of our problems. But monetary policy–and full-scale negative interest rate policy in particular–is the primary answer to the problem of insufficient aggregate demand. It is a bad thing when world leaders say or seem to say the opposite. As the title of Martin Sandbu’s excellent column on ft.com proclaims: “Central banks cannot pass the buck.”

Mark Carney’s Description of the Transmission Mechanism for Negative Interest Rates

Here is the key passage from Mark Carney’s speech:

Central bank innovation has now extended to negative rates, with around a quarter of global output produced in economies where policy rates are literally through the floor.

Conceptually the more that effective policy rates can be reduced below equilibrium rates, the better the prospects for demand to grow faster than potential supply, promoting global reflation.

However, it is critical that stimulus measures are structured to boost domestic demand, particularly from sectors of the economy with healthy balance sheets.  There are limits to the extent to which negative rates can achieve this.

For example, banks might not pass negative policy rates fully through to their retail customers, shutting off the cash flow and credit channels and thereby limiting the boost to domestic demand.7  That is associated with a commonly expressed concern that negative rates reduce banks’ profitability.

To be clear, monetary policy is conducted to achieve price stability not for the benefit of bank shareholders.

Nonetheless, when negative rates are implemented in ways that insulate retail customers, shutting off the cash flow and other channels that mainly affect domestic demand, while allowing wholesale rates to adjust, their main effect is through the exchange rate channel.

From an individual country’s perspective this might be an attractive route to boost activity. But for the world as a whole, this export of excess saving and transfer of demand weakness elsewhere is ultimately a zero sum game.  Moreover, to the extent it pushes greater savings onto the global markets, global short-term equilibrium rates would fall further, pulling the global economy closer to a liquidity trap. At the global zero bound, there is no free lunch.8

For monetary easing to work at a global level it cannot rely on simply moving scarce demand from one country to another. Instead policy needs to increase primarily domestic demand, with the exchange-rate channel more a side effect that accompanies any monetary policy action.

In any given country, a monetary expansion aimed at boosting domestic demand will tend to reduce effective interest rates relative to their equilibrium level, generating an excess of domestic investment over domestic saving that must be met with a capital inflow from abroad.

But viewed from overseas, the corresponding capital outflow will tend to raise the short-term equilibrium rate (Chart 12), giving conventional monetary policy overseas more traction.

In this way, the rising tide of global demand would raise all boats.

Why It is OK for Regular Households to Be Insulated from Negative Deposit Rates

In “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” I argue that it is not only OK for small deposits (say the first 1000 euros in average monthly balances per person) to be exempted by private banks from negative rates to the extent those banks choose to do so, but that this should be encouraged by an effective subsidy built into the central bank’s formula for interest on reserves. One reason this is OK is that most of the assets and liabilities in the economy are held by firms and a small share of the people, so there is plenty of transmission mechanism left if only large accounts and commercial accounts are subject to the negative interest rates. I do agree with Mark Carney that it is very helpful to encourage banks to pass along negative interest rates to large accounts and commercial accounts. 

The kind of central bank subsidies I suggest in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies,” combined with the encouragement to pass along negative interest rates to the large accounts and commercial accounts can go a long way toward maintaining bank profitability. 

Negative Interest Rates Can Do Their Work Even Outside of the Foreign Exchange Markets

Let me set aside the foreign exchange markets for a moment by imagining that interest rates are being cut by 1 percentage point by all the central banks in the world. In some countries this would be a cut to a lower positive interest rate. In other countries, it would be a cut to a negative interest rate or to a deeper negative interest rate, which for countries already at significant negative interest rates might call for lowering the paper currency interest rate as well. (See “If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal.”) Since all countries would be cutting their rates by 1 percentage point in tandem, there should be only modest effects on international capital flows and hence only modest effects on exchange rates and trade balances.

The effects of this interest rate cut would be quite similar for countries that were cutting their rates in the positive region and countries that cut to a negative rate. As I wrote in “Negative Interest Rate Policy as Conventional Monetary Policy”:  

As far as I know, very few economists have objected to permanently raising the inflation rate as a way to deal with the zero lower bound on the basis that this would not, in fact, allow any extra monetary stimulus. The reason is the fact I started with: standard models say it is the real interest rate that matters. But if it is the real interest rate that matters, lowering the nominal interest rate without raising inflation will stimulate the economy through totally standard mechanisms. It is not necessary to have full agreement on exactly how a lower real interest rate stimulates the economy. For all of those who agree that interest rate policy matters, a cut in the nominal interest rate will have much the same effect as an increase in inflation with the nominal interest rate held fixed. So if an increase in inflation operates through conventional means, so does a cut into negative territory of the full set of nominal government interest rates – target rate, interest on reserves, lending rate, between- tax-year rate, postal savings rate and paper currency interest rate. In that sense, a negative interest rate policy is a conventional monetary policy if having a target inflation rate of 2 per cent or 4 per cent instead of a target inflation rate of zero is a conventional monetary policy.

With a global cut in interest rates by 1 percentage point, different countries are getting to a low real interest rate in different ways–some in part by having had higher inflation to begin with, some by negative nominal interest rates–but the effects are similar. 

But negative interest rates seem new enough, that it is worthwhile to review the wide range of transmission mechanisms by which lower interest rates increase aggregate demand. Here is the basic story: In any nook or cranny of the economy where interest rates fall, whether in the positive or negative region, those lower interest rates create more aggregate demand by a substitution effect on both the borrower and lender, while other than any expansion of the economy overall, wealth effects that can be large for individual economic actors largely cancel out in the aggregate.

The Principle of Countervailing Wealth Effects: It is easy to forget about some of the wealth effects. Applying the general principle that all the wealth effects cancel–other than overall expansion of the economy and differences in the marginal propensity to consume across economic actors can help in making sure one hasn’t missed a wealth effect, much as double-entry accounting helps in making sure one doesn’t miss something. An example of a particularly large wealth effect that is easy to miss is that a fall in interest rates raises the present discounted value of household labor income. The other principle that helps to avoid missing a wealth effect is to remember that there is always another side to every borrowing-lending relationship. If the economic actor on one side of the borrowing-lending relationship gets a negative hit to effective wealth, the economic actor on the other side will get a positive boost to effective wealth–again with the exception of the overall expansion of the economy.  

The Effect of Redistributions: Redistributions from economic actors with a high propensity to consume to economic actors with a low propensity to consume might reduce the aggregate demand effect, but as an analysis like the one that Adrien Auclert does in “Monetary Policy and the Redistribution Channel.” shows that (a) the effects from such redistributions are modest (though definitely big enough to be worthy of Adrien’s effort at studying them) and (b) in the aggregate they tend to go in the same direction as the substitution effect. For understandable reasons, the modest overall size of the redistribution effects is not highlighted in the abstract but the fact that these redistributions act in the same direction as the substitution effect is. Note the word “amplify”:

This paper evaluates the role of redistribution in the transmission mechanism of monetary policy to consumption. Three channels affect aggregate spending when winners and losers have different marginal propensities to consume: an earnings heterogeneity channel from unequal income gains, a Fisher channel from unexpected inflation, and an interest rate exposure channel from real interest rate changes. Using a sufficient statistics approach, I show that the latter is plausibly as large as the intertemporal substitution channel in Italian and in U.S. data. A calibrated model reveals that this channel is particularly potent when asset maturities are short, and that the other two redistributive channels can also amplify the effects of monetary policy.

My proposals would have only a limited effect on redistribution channels. I can think of only two: 

  • Effective subsidies through the interest-on-reserves formula to encourage banks to exempt small accounts from negative interest rates tend to make interest rate cuts more favorable for spending by avoiding taking funds from households likely to have a high marginal propensity to consume. 
  • People using paper currency for tax evasion may well have a high marginal propensity to consume, but the more serious criminals who hold most of the rest of paper currency probably have a low marginal propensity to consume; laundering money into legitimate-enough businesses that it is safe to spend the money takes time, so for the most financially successful criminals consumption must often be deferred. (Think of the trouble the protagonists in “Breaking Bad” had in spending their money in the present without calling too much attention to themselves.) Lowering the paper currency interest rate is mostly a transfer from criminals of these two types to the central bank, where it either adds to central bank independence or is sent on to the remainder of the government. And in most countries, the rest of the government probably has a fairly high propensity to consume funds transferred to it from the central bank. (Indeed, in the US, there is an increasing and dangerous trend, not toward demanding the Fed generate more seignorage revenue, but toward demanding that the Fed hand over seignorage revenues it makes in the normal course of its businesses more quickly precisely because it is a way to spend more money without running afoul of anti-deficit rules.)

Why Wealth Effects Would Be Zero With a Representative Household: It is worth clarifying why the wealth effects from interest rate changes would have to be zero if everyone were identical. In aggregate, the material balance condition ensures that flow of payments from human and physical capital have not only the same present value but the same time path and stochastic pattern as consumption. Thus–apart from any expansion of the production of the economy as a whole as a result of the change in monetary policy–any effect of interest rate changes on the present value of society’s assets overall is cancelled out by the effect of interest rate changes on the present value of the planned path and pattern of consumption. Of course, what is actually done will be affected by the change in interest rates, but the envelope theorem says that the wealth effects can be calculated based on flow of payments and consumption flows that were planned initially.  

Examples of Channels of Transmission of the Effects of Interest Rate Cuts to Aggregate Demand

Interest rates show up in many parts of the economy. Generally, interest rates move up and down together. Those where there is more risk of default or where money is locked up for longer periods of time tend to have a higher average level, so a move to negative short-term safe rates is likely to mean lower, but still positive rates for most consumer loans and bank loans, for example. It is worth taking a look at how, in each borrower-lender relationship, lower interest rates tend to stimulate aggregate demand overall. It is also good to notice how a loan done in a regular bank office is only a small share of all borrower-lender relationships. 

Mortgages: Houses are easier to buy and to build when interest rates are lower. The effective wealth of those who own mortgages tends to go down when interest rates fall, especially when people use a prepayment option to refinance at a lower interest rate, but those who need to pay the mortgage get a corresponding improvement in their financial situation that enables them to spend more. Those who need to pay the mortgage typically have a higher propensity to consume. 

Car Loans: Cars are easier to buy when interest rates are lower. This stimulates aggregate demand, and is mostly a substitution effect. Car buyers and car dealers benefit from lower interest rates. Their increased effective wealth makes up for the reduction in effective wealth of those who own securities backed by car loans who hope to roll over their existing loans into more car loans. Apart from the effects of that loss in effective wealth, those looking to roll over car loans they hold into more car loans have an incentive to shift the spending of what resources they have left toward the present over the future. That substitution effect also contributes to aggregate demand.

Venture Capital: It is easier and cheaper to get money for a startup when interest rates are low. This has a substitution effect toward more burn to write new software or develop a new medical treatment. There are wealth effects favoring those who have ideas over those who have a pile of money to invest. Those who have ideas tend to have a higher propensity to spend on making their ideas a reality (not consumption spending, but spending nevertheless) than the propensity of those with the pile of money to invest to spend on their own.   

Commercial Paper: Those whose bank accounts would exceed the limit for being shielded from negative interest rates need to put their money somewhere. For large amounts of money, paper currency is not that attractive to begin with, and can be kept from being too attractive by keeping the paper currency interest rate equal to the central bank’s target rate (say the federal funds rate or a repo rate). So those who want to hold liquid wealth are still likely to want to have some version of money market funds, even when they have a negative interest rate. Or it may be that a new type of fund would arise serving the same function. Lower interest rates make it less costly for businesses to borrow in the commercial paper market and so make it easier for those businesses to make it from one month to the next without running out of funds. These businesses may even feel they can take a somewhat bigger risk in the direction of expansions. Those with part of their pile of funds invested in the commercial paper market suffer a loss in effective wealth, but that is made up for by the increase in effective wealth of those borrowing in the commercial paper market. Leaving aside those wealth effects, those with their funds invested in the commercial paper market have a bit of a substitution effect in favor of consuming more.     

Firms with Cash Hoards: Farthest from needing any bank loan are companies that already have large liquid asset hoards that under current interest rates, they see as earning a better risk adjusted returns sitting and earning interest than if invested in a new factory, new machinery, or a new business venture. When interest rates go down, these firms will begin to pay a heavy price for simply earning interest with a liquid asset hoard, and those within the company who want to champion a new business venture will meet with more success in internal corporate deliberations. This is particularly valuable for the economy if firms were applying too high a hurdle rate for proposed projects even at the old higher interest rate as Clay Christensen and Derek van Bever argue in their Harvard Business Review article “The Capitalist’s Dilemma.” In this context, negative interest rates might help greatly in getting not only the CFO but also the production and sales side of the firm to realize that interest rates are low, and what that should mean for business decisions. 

Governments and Treasury Bill Holders: Those who like to roll over their wealth in the form of short-term Treasury Bills are likely to be especially unhappy about low interest rates. But their loss is the government’s gain. And since lower interest rates on Treasury Bills show up as a reduction in conventional measures of the government budget deficit, this money is especially likely to be spent by the government. So the redistribution in this case tends to lead toward more aggregate demand. 

Many people have been frustrated that the substitution effect for government investment is so low. Most governments seem to pay too little attention to interest rates in deciding whether an investment project such as refurbishing roads and bridges is a good idea or not. But it is unlikely that the logic that low interest rates make government investment projects a better idea will forever fall on deaf ears in every nation in which interest rates fall. 

Governments and Holders of Long-Term Government Bonds: It may well be that negative interest rates in most countries are preceded by quantitative easing that shifts government financing decisively toward Treasury bills. But there are likely to be some long-term government bonds left. In this case, there is much less of a redistribution between the government and the bond-holders. The committed payments stay the same for some time. The market value of the long-term bonds will change, but the present discounted value of the tax revenues slated to be used to make the payments on those bonds will change in a similar way. For the taxpayers, that change in the present value of the tax payments is in turn cancelled out to an important extent by the change in the present value of the income out of which those tax payments will be made. 

With less redistribution, it makes sense to focus on the substitution effect even more than in the other examples above. As mentioned above, the substitution effect for the government may be low (much lower than it should be), but the holders of the long-term bonds have reason to shift their consumption forward in time.

Central Bank Lending: Eric Lonergan is right to emphasize in his post “There is a lot more the ECB can do” the value of central banks lowering the central bank lending rate (such as the discount rate in the United States) as part of a negative interest rate policy. As Martin Sandbu points out in “Central bankers’ feigned impotence” on ft.com, this needs to be done along with the central bank lowering the other interest rates it controls–otherwise private banks can borrow from the central bank and then park the money at a higher interest rate in the repo market or their reserve accounts after enough reshuffling to provide a bit of a fig leaf to pretend to hide what they are doing. Note here that it is the rate on extra reserves that needs to be in line with the lending rate. 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,” an effective subsidy by having a higher rate on inframarginal reserves is actually helpful. 

If the central bank lending rate is in line with the target rate and interest on reserves, any redistribution is between savers and those banks borrowing from the central bank, with the central bank only a conduit and not itself subject to much of a wealth effect. But the positive wealth effect for banks is particularly important, since it helps preserve the bank capital needed for financial stability (hopefully in conjunction with a high capital conservation buffer that avoids the dissipation of scarce bank capital into dividends). And as in any other borrowing and lending relationship a lower central bank lending rate will have some substitution effect in favor of more spending–in this case through a certain amount of extra lending by the private banks that borrow from the central bank. 

Returning to the Effects of Interest Rate Cuts on International Capital Flows and Exchange Rates

I hope the examples above show that the aggregate demand effects from lower interest rates–including negative interest rates–do not depend solely on international capital flows. It should be mentioned that even if all the nations in the world cut interest rates, there would be some interesting international effects. For example, China is a large holder of Treasury bills. If interest rates were to fall, there would be an important redistribution away from China toward the US. But let me now leave that aside. 

The international effects Mark Carney is focusing on come from one country cutting its interest rates more than another. This leads to flows of funds from the now lower rate country toward other countries that have not cut their rates, as those funds seek a good return. As I discuss in “International Finance: A Primer,” the fact that foreign assets are purchased directly or indirectly by domestic currency then makes the rest of the world awash in domestic currency–more than the rest of the world outside the domestic currency zone wants. Exchange rates adjust until the domestic currency makes it way back to the domestic currency zone–primarily to pay for an increase in net exports.

Given the fact that negative interest rates would work for the whole world and so are not zero-sum, the fact that the early adopters get an extra kick from higher net exports is a feature, not a bug. As I argued in “Could the UK Be the First Country to Adopt Electronic Money?” and in my presentation “18 Misconceptions about Eliminating the Zero Lower Bound,” these international effects are likely to hasten the spread of negative interest rates as part of the monetary policy toolkit.

International effects can indeed be central for a small open economy such as Switzerland, Sweden or Denmark, and substantial even for an economy as large as the eurozone economy. And if a central bank gets enough extra aggregate demand quickly from international effects, it is unlikely to continue cutting interest rates far enough to see much action from the other channels. But if other central banks cut interest rates too in accordance with what their own economies need, then the central banks that started the round are more likely to find they need to cut interest rates far enough for the other channels to kick in in a big way.  

When people ask about how effective negative interest rates are at stimulating aggregate demand, I always emphasize that interest rate cuts–in either the positive or negative region–should be judged by how much they do per basis point. One should not expect a 10 basis point (.1%) cut to have a huge effect simply because it is in the negative region. For those countries that choose as a matter of policy to keep their effective lower bound on interest rates by keeping the paper currency interest rate at zero, there may not be enough basis points to cut to have a big effect on aggregate demand. But for any central bank willing to go off the paper standard, there is no limit to how low interest rates can go other than the danger of overheating the economy with too strong an economic recovery. If starting from current conditions, any country can maintain interest rates at -7% or lower for two years without overheating its economy, then I am wrong about the power of negative interest rates. But in fact, I think it will not take that much. -2% would do a great deal of good for the eurozone or Japan, and -4% for a year and a half would probably be enough to do the trick of providing more than enough aggregate demand. 

International effects do matter; such a salutary rate cut by the eurozone and Japan would probably mean the US and the UK would need to go to milder negative interest rates in order to stay on track itself. But if the US and UK did so, such rate cuts in the eurozone, Japan and the United States and the United Kingdom would bring about a big expansion of aggregate demand for the whole world.      

On the transmission mechanism for negative interest rates, also see “On the Need for Large Movements in Interest Rates to Stabilize the Economy with Monetary Policy

For links to everything I have written about negative interest rates, see “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”