The Natural Interest Rate. Mark Carney is remarkable in many ways. He was chosen as Governor of the Bank of England despite being a Canadian. He has been a leader in pushing up equity requirements for banks in the real world–a key for financial stability. And in his August 4, 2016 press conference, he has given the most articulate statement for the press and the public that I have heard for the view that central banks must now use a lower range of interest rates for economic stabilization than before because supply-side forces have brought down the natural rate of interest. Central bankers all over the world, including in the United States, would be well-advised to study carefully how Mark Carney handles the questions in this press conference, particularly on the issue of how hard low interest rates are on savers.
I have no doubt that Mark Carney’s understanding of what is happening with the natural interest rate has been informed by the excellent report on this issue by Bank of England economists Lukasz Rachel and Thomas Smith:
- Drivers of long-term global interest rates – can changes in desired savings and investment explain the fall?
I highly recommend it.
Conceptually, I write about the natural interest rate in these two posts:
Mark Carney’s particular point that central banks do not control the medium-run natural interest rate was also made by Mario Draghi. See this post:
- Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate
Negative Interest Rates and Bank Profits. The one unfortunate note in Mark Carney’s August 4, 2016 press conference was his speaking against negative interest rates. But he did ably undercut his own reason for being against negative interest rates. Mark Carney’s reason for being against negative interest rates is that they are hard on banks, backing up my claim in “What is the Effective Lower Bound on Interest Rates Made Of?” that the effective lower bound is now primarily made of central bank concerns about bank profits. But there are many ways for central banks to support the profits of private banks. One is by reducing the rate at which the central bank lends to private banks. In his press conference, Mark Carney explained in some detail how the Bank of England had closely calculated how to use that kind of mechanism to cancel out the effects of other rate cuts on bank profits. So the Bank of England knows well how to support bank profits when interest rates are cut–and could do so even if rates were cut into the negative region. Another way for obvious way for central banks to support bank profits is to use a multi-tier interest on reserves formula. I write about this in
- How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies
A third way to support bank profits when interest rates are lowered is to reduce the paper currency interest rate, as I discuss in
- If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal
Banks live on spreads, so a good way to keep from adding stress to banks by central bank policy is to lower all government-controlled interest rates (including the paper currency interest rate) an equal amount. Then the government can avoid the problems that arise when the government effectively competes for funds with banks by having too high a paper currency interest rate. Beyond these three mechanisms, it is quite unlikely that a roomful of competent economists would have all that much trouble in thinking of other ways to throw funds to banks in order to keep them from being stressed out too much by rate cuts, if that is a genuine concern. For governments that have any substantial amount of short-term debt in the hands of the public, the budgetary savings from lower interest rates guarantee that such governments can easily afford such subsidies to banks should they think them necessary (though in many countries the budgetary savings may show up in the balance sheet of the non-central-bank part of the government).
As an aside, I should mention that in an effort to discourage other countries from using negative interest rates too freely, Mark Carney used some faulty analysis, as I discuss in
The Need for Supply-Side Reform. The fact that unfavorable supply-side forces are pushing the natural interest rate down gives one more reason to pursue supply-side reform. I view stabilization through a vigorous interest rate policy–including use of negative interest rates where needed–as a complement to supply-side reform, not a substitute. Both are needed, and both reinforce each other.