Central banks have spent the past few years exploring increasingly uncharted waters, trying to pull the economy out of its post-crisis funk with a panoply of new measures, including bond buying on a huge scale, three-year lending to banks, and even modest equity purchases. This year, another quiet central bank revolution has been taking shape, in the relationship between monetary and regulatory policy.
Each of these has important implications for the other. For example, easy monetary policy can contribute to financial imbalances by boosting asset prices and fueling a reach for yield. The pre-crisis central bank orthodoxy was that asset price bubbles were no concern of monetary policy: it was impossible to identify bubbles in advance, and in any case all but impossible to halt them on the way up, so the role of monetary policy was simply to mop up after the bubble burst. The financial crisis upended that orthodoxy, and central banks are now taking financial stability into account when setting monetary policy. Most importantly, financial stability concerns are one reason for the Fed’s shift towards tapering down its bond purchases. And both the Bank of Canada and Sweden’s Riksbank have cited worries about financial imbalances in deciding not to ease policy in the face of low inflation.
Just as monetary policy affects financial stability, regulatory policy also has implications for monetary conditions. For example, the global push to make banks safer has also surely limited their appetite to lend to some degree, slowing the economy, and meaning monetary policy stays loose for longer. The Euro area, where next year’s Asset Quality Review and stress tests are looming over banks, is a case in point here.
Central banks are now also seeking to change regulatory policy proactively over the course of the cycle. A key advantage of this approach is that it can, in principle, target pockets of financial froth, without affecting the wider economy, for example by curbing lending to residential or commercial property. The Bank of England’s decision last week to end its cheap funding for new mortgage lending is one example of this, as is the Reserve Bank of New Zealand’s (RBNZ) recent restriction on high-loan-to-value mortgage lending. Ideally, tighter regulatory policy allows monetary policy to support the economy for longer. The problem is that nobody can say with any confidence just how much counter-cyclical regulatory policy will slow the economy. The RBNZ has estimated that its new measures are equivalent to a 30bp rate hike, but only time will tell how accurate that estimate will turn out to be.
As the global recovery gathers pace, central banks are likely to step up counter-cyclical regulatory measures. In time, these measures are set to become a key part of the central bank toolkit. But, in the near term, we think investors will be skeptical over how much tighter regulation can substitute for conventional monetary tightening, until there is more concrete evidence of the impact of counter-cyclical regulation on the economy.
The notion of negative deposit rates has been on a low simmer since July 2012 when the European Central Bank (ECB) cut their “deposit facility rate” to zero percent, and the Danish central bank lowered their own deposit rate to a negative level (-0.20%) in response. The noise and concern around this subject matter has recently intensified as central bankers have explicitly acknowledged the idea. Cuts to either the ECB deposit rate or the Fed’s Interest on Excess Reserves (IOER) rate could conceivably result in negative deposit rates for actual Main Street bank customers if historical linkages remain intact. This idea, in and of itself, is fascinating to contemplate. In our view, crossing the Rubicon to negative deposit rates may represent a breakdown of traditional norms of stimulative monetary policy, with potential consequences that are actually contractionary. Central bankers who set these policies are well aware of a potential reversal in effectiveness. As such, we agree with the hypothesis that policymakers are hinting at negative rates more as a communication tool to signal their level of accommodation bias, rather than as a policy they might actually employ in a meaningful way.
The ECB deposit facility rate, at zero percent, is already 25 basis points less than the Fed’s IOER rate, and so optically it appears the Fed has some room to cut. However there’s a catch: the Dodd-Frank law enacted in 2011 dramatically changed the assessment scheme for FDIC insurance premiums that US banks must pay. An excellent paper from the BIS earlier this year detailed many of the consequences of this change, but one of them is that even though the IOER rate is currently 25bp, any meaningful cut in the IOER could bring the effective policy rate negative for many banks after their FDIC insurance premium assessments.
Conventional economic wisdom states that lower policy rates are economically expansionary and inflationary. An economy suffering under recession and stubborn lack of “good” inflation, or one with persistent labor market weakness and lackluster growth (sound familiar?) ought to call for lower policy rates. Is there something sacrosanct about the zero bound? If lower deposit rates encourage more investment all else equal, then charging depositors to hold their money would surely be ample encouragement to invest, no? We believe it would be stimulative at the margin; however, there are at least a few complications that need to be considered.
1) The potential for hoarding of physical cash. If a depositor withdraws her deposit to “invest” in higher yielding Federal Reserve Notes, i.e. physical cash, the total amount of deposits in the system decreases, and that is contractionary rather than stimulative. Mitigating the risk of theft is not costless, and as such there is some modest level of negative interest a depositor might agree to pay a bank for this service, but any appreciable difference may result in system-wide deposit reductions. Loss of deposits is harmful to the banking system, and so it seems counterproductive to pass on negative deposit rates to Main Street if the consequence is withdrawals in cash. The Danish experience tends to support this notion, where Main Street bank deposit rates decoupled from the central bank deposit rate as the latter went negative.
2) In order to avoid point #1, the borrowers in the economy and the banks themselves tend to bear the cost of negative short-term risk free rates, rather than the depositors. This results in system-wide cost of capital increases if excess reserve balances held at the central bank are structural and cannot decline meaningfully, which was the case in Denmark, and is in the US (for reasons discussed below). The negative policy rate erodes the banks’ capital base if there is no offset somewhere else. Again, in the case of Denmark, the banking system increased the rates charged to some borrowers and experienced capital erosion, when they could not meaningfully pass through negative rates to Main Street depositors. Decreased bank capital and increased borrowing rates in the economy would be contractionary rather than stimulative.
The excess reserves currently in the banking system were created by the Fed as payment for the securities purchased through quantitative easing. These reserves are structural, and the idea that reducing the interest paid on “excess” reserves will somehow “get banks lending again” indicates to us a misunderstanding of the state of the US banking system. Many will be quick to point out that as banks lend, excess reserves get converted into required reserves. This is correct; however, the scale of lending needed to work off the excess reserves currently in the banking system is massive. Even at a 10% reserve requirement, the total US banking system balance sheet would need to increase by more than $20 trillion, or 144%, in order to migrate the current reserve balance from excess to required.
Having shown the amount of excess reserves inside the banking system is mainly fixed, it becomes easy to see why lowering IOER to an effectively negative rate can have serious implications on money markets and bank balance sheets.
When the Fed cites “potential disruptions in the money market” to those who question the wisdom of paying IOER, we view this as a central banking euphemism for the mind-bending effects of breaking the sacrosanct zero bound illustrated above, some of which are intensified by the other extraordinary policies. They know this better than we do, and so we agree that meaningfully negative policy rates are probably off the table, at least without other facilities to offset the effects.
 Danish monetary policy is subject to complexities which are beyond the scope of this discussion, but simplistically, this initial foray into negative deposit rates was helpful in their endeavor to maintain the peg between the krone and the euro which was a benefit that justified the move.