Markus Brunnermeir and Yann Koby's paper "The Reversal Interest Rate" has a title and an abstract so intriguing for those interested in negative interest rates that I need to discuss it. Here is the abstract:
The "reversal interest rate'' is the rate at which accommodative monetary policy "reverses" its effect and becomes contractionary. The reversal interest rate depends on various factors: (i) banks' asset holdings with fixed (non-floating) interest payments, (ii) degree of interest rate pass-through to loan rate and deposit rate, (iii) amount of bank's whole sale funding. Quantitative easing (QE) increases the reversal rate. QE should only employed after interest rate cut is exhausted. Moreover, low interest rates beyond the time when fixed interest rate mature undo its effectiveness, suggesting a different forward guidance policy.
Ruchir Agarwal and I had a chance to talk to Markus Brunnermeier at the Bank of International Settlements when we went to present our paper "Breaking Through the Zero Lower Bound" there on November 17, 2016.
Markus was very gracious in our conversation. Ruchir and I explained our interpretation that the Markus and Yann's "reversal interest rate" was all about the effects of low interest rates on bank profits and therefore bank balance sheets. (This is along the lines of my post "What is the Effective Lower Bound on Interest Rates Made Of?") Markus agreed with that interpretation, and with the idea that central banks can help counteract the profit and balance sheet effects of negative interest rates with other policies.
What this means is that the reversal interest rate can be pushed down as low as needed if steps are taken to to keep bank balance sheets healthy. One possible step to maintain bank profitability and bank net worth in a negative interest rate environment is to reduce the paper currency interest rate, so that banks are able to lower the rates they pay depositors without having to worrier about depositor flight into paper currency. This approach is in line with what I write 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."
Another possible step to maintain bank profitability and bank net worth is for the central bank to effectively make transfers to private banks. Tiered interest on reserve formulas in which higher interest is paid on reserves up to a certain level is one way to do this. The Swiss National Bank and the Bank of Japan both do this. Loans from the central bank to private banks at below market interest rates are another way to effectively make transfers to the private banks. The European Central Bank does this. Thus, effective transfers from the central bank to private banks are already current policy for many central banks that have used negative interest rates. So this is a highly relevant type of policy.
I talk about an interesting variant on the tiered interest on reserves approach in these posts:
- How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest on Reserves Policies
- Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target
- The Bank of Japan Renews Its Commitment to Do Whatever it Takes
- Why Central Banks Can Afford to Subsidize the Provision of Zero Rates to Small Household Checking and Savings Accounts
It seems likely that inventive central bankers could easily come up with other mechanisms for effectively transferring funds to private banks to keep their profits and net worth healthy, and so avoid a binding reversal interest rate. Thus, though the concept of a "reversal interest rate" is quite intriguing, it is not a serious barrier to negative interest rate policy. Rather, the concept of a "reversal interest rate" points to the operational importance of central banks keeping an eye on bank profits and bank balance sheets when lowering interest rates.
In keeping with an attention to bank balance sheets, it can't be emphasized too much that negative interest rate policy is highly complementary with high capital conservation buffers for banks that keep banks from making their balance sheet weaker by paying dividends or buying back stock unless the balance sheet is very strong to begin with. On this, see
- Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy