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The Trouble With Negative Interest Rates

As you might remember, Sweden's Riksbank is now charging a negative interest rate (-0.25%) on excess reserves. But Scott Fullwiler thinks that this won't have the intended effect of moving cash into circulation:

Instead of providing an incentive for banks to lend, banks instead will have an incentive to rid their balance sheets of reserve balances. ... [U]nless the central bank takes action to drain the reserve balances, the undesired excess quantity will just lead banks to bid the overnight rate down to the rate paid on reserve balances, if it’s not already there (as in the US...).
And what is the effect? For banks holding the extra balances not drained by the central bank, the effect is a reduction in their income, as they have to transfer income to the central bank to pay the tax. This then, in the case of the US, would raise the Fed’s profits (all things equal) and thereby raise the amount the Fed turns over to the Treasury (since the Fed turns its profits after paying a fixed percent dividend to member banks). So . . . instead of helping banks lend via monetary easing, we again have a fiscal tightening, as the government’s budget deficit has been reduced, however marginally. Further, by reducing bank profits, you reduce bank capital . . . again probably marginally, but nonetheless, not the most intelligent thing to do in the midst of a banking crisis.

I don't know if I completely buy Fullwiler's argument. First off, by issuing loans against excess reserves, banks increase the money supply and in turn reduce reserve balances. That's why so many monetarists have (needlessly) been worried about the possibility of high inflation. But banks haven't been lending out excess reserves, most likely to keep a bit of a cushion in case of a cash crunch, or because they've tightened lending standards, or because demand has fallen, or because they're now earning interest on those reserves. If the U.S. introduced a tax on excess reserves, banks could avoid it by loosening standards or purchasing securities and thereby injecting cash into the economy--which is the whole idea. (Negative rates proponent Scott Sumner wants banks to buy Treasuries.)

Which, I suppose, is one place I'm sympathetic to Fullwiler's argument against negative interest rates on reserves: It seems like an overly complicated way of stimulating the economy.

The situation in Sweden is a little different from here in that the central bank doesn't have a quantitative easing policy and banks haven't accumulated much in the way of excess reserves. For what it's worth, here are the minutes of the latest Riksbank monetary policy meeting, in which one of the central bankers, Princeton's Lars Svensson, talks about the pros and cons of negative rates: (The repo rate in Sweden is similar to the fed funds rate here. The Swedes keep the interest rate on excess reserves at a set .50% below the repo rate, so the zero percent Svensson talks about below would mean a -0.50% rate on excess reserves.)

Deputy Governor Lars E.O. Svensson began the discussion by pointing out that with regard to the lower limit for the repo rate there is a need to differentiate between what is possible and what is desirable from a monetary policy point of view. In the discussion about how far it is possible to lower the interest rate, something of a zero interest rate mystique has arisen which has exaggerated the problems relating to a zero interest rate. The zero interest rate bound does not apply to financial markets; they can handle negative interest rates if necessary. It is the relative prices between financial assets that matter. Interest rates are only one way of expressing relative prices; the price today of kronor tomorrow. If we take a 12-month treasury bill of a nominal value of SEK 100 000, there is no fundamental difference if today it has a price of SEK 99 000, 100 000 or 101 000, which would mean nominal interest rates of approximately 1, 0 or -1 per cent. In other words, there is nothing strange about negative interest rates...The banks can also use charges to introduce what in reality are negative interest rates on transactional accounts.

The only reason why the concept of a zero interest rate has attracted so much attention is that there are banknotes. Banknotes yield zero interest. If households, companies and investors think that the rate of interest on their accounts is too low they can withdraw cash from these accounts and instead keep large amounts of banknotes in their safes, suitcases and closets. However, taking the handling costs into account, including crime-prevention measures, storage costs and so on, banknotes provide an actual yield that corresponds to a negative interest rate. The lower limit for the interest rate is thus not dependent on the financial markets but is determined by the interest rate at which households, companies and investors would begin to hoard large volumes of cash in the form of banknotes. It is probable that the interest rate could become negative before this happened, but we can not be certain where the lower limit lies. It is, however, possible to draw the conclusion that a policy rate of zero per cent would not necessarily entail any significant problems, especially in the light of experience in Japan, where the policy rate has been 0 and is now 0.1 per cent, in Switzerland, which has a target for the three-month Libor rate of 0.25 per cent and a repo rate of 0.05 per cent, and in the USA, where the federal funds rate is restricted to the interval between 0 and 0.25 per cent.

--Zubin Jelveh