This week’s policy decision by ECB is historic. For some time now, a number of economists have suggested that dual interest rates are the logical next step in the arsenal of central banks.[1] Dual interest rates refers to a policy where central banks independently target the rates at which they lend to banks and the rates at which they remunerate deposits at in order to stimulate demand. Dual interest rates always work. If lending rates fall below deposit rates the central bank is transferring money to the private sector. If access to this transfer is linked to extending loans, such as under the ECB’s TLTRO, the power is amplified.
Several months ago, I suggested that the ECB raise the deposit rate, which they pay on bank reserves to zero, and that they slash the interest rate on TLTROs to a fixed -1% for up to ten years. On reflection, and after exchanges with a number of policy-focused economists on Twitter[2], I am reasonably convinced that they have in fact done something very similar to this. In this era of central bank obfuscation, it has taken several days of reflection and calculation, to work this out. The net result of this barrage of measures, however, is in fact to raise the interest rate on the interest paid on bank reserves in the Eurozone, while cutting the ECB’s ‘lending rate’ – the interest rate on TLTROs. (See technical note below for calculations.)
Specifically, the ECB has moved to a zero interest rate on excess reserves up to 6x required reserves. Banks with excess reserves below this level can now borrow reserves at negative rates and deposit with ECB, generating positive carry. Furthermore, using TLTROs banks will be able to borrow from the ECB itself at -0.5% under certain conditions and earn positive carry if these transactions result in them holding higher excess reserves, but less than 6x required reserves. The distributional consequences between northern and southern Europe are not completely clear, but my initial thoughts are that it creates an incentive for banks in Northern Europe holding reserves in excess of 6x their required holdings to effectively lend these reserves to banks in Southern Europe.
On reflection it is astonishing this has been approved. TLTROs and tiered reserves are a far more significant monetary innovation than QE. Macro policy econs need to wake up on this. If legal, the limits to monetary policy have just been lifted.
The critical psychological breach is a central bank engaging in a marginal increase in reserves which under certain conditions will generate negative net interest margin to the central bank. Official interest rates are now having the net effect of transfers to private sector.
Be in no doubt. Dual rates is monetary rocket-fuel. In contrast to standard negative rates, to forward guidance, or QE, the marginal effects of these policies are increasingly powerful. I am not convinced that this specific combination of measures will suffice to generate enough demand to create an acceleration in Eurozone activity – but it will help. But further move along these lines will have increasingly impact. For example, cutting the TLTRO rate further and paying zero interest on a larger share of reserves, would have an even greater effect.
There is little doubt, that the ECB under Mario Draghi, has been a source of hugely clever innovation, and deft political skill. Obfuscation may be the inevitable price we have to pay. The populists on the polar extremes of this argument, have so far been too lazy or too dumb to work it out.
Hats off to Draghi. He parted with a dismissal of ‘monetary innovation’ having just landed one of the most significant innovations monetary history. Media coverage to date appears oblivious to the significance.
Technical note
the ECB now has three tiers of reserves: 1) Minimum or required reserves (MRR); 2) excess reserves which are a multiple of the MMR (currently 6x), remunerated at zero percent; and 3) additional excess reserves, which pay the deposit rate, which is currently -0.5%. According to ECB data, there are €1.2trn on excess reserves, and the average reserve requirement is €132bn. On my understanding, up to €900bn is on zero percent interest rates. The remaining €435bn is paying -0.5%, ie €2.2bn, or an average interest rate of -16bps on all reserves. By contrast, the best rate that can now be received on a TLTRO is -0.5%. Prior to these changes, the banking system was paying 0.4% on €1.2trn of reserves, or €4.8bn, or -35bps on average. The net effect therefore is to have reduced the negative rate on bank reserves in aggregate and cut the rate at which banks can receive funding under TLTROs. The ECB has just moved the dual rates in opposite directions.
References
[1]See Megan Greene, here. Simon Wren-Lewis, here, and Eric Lonergan, here.
[2]Including Gregory Claes, Chris Marsh, and Megan Greene.
Great note (as always). On the technical part, you seem to point to the reserves sitting at the ECB’s current account, but I believe the total sum of excess reserves should also include an extra EUR 0.55tn parked at its deposit facility
https://www.ecb.europa.eu/mopo/implement/sf/html/index.en.html
– making the whole total of excess liquidity closer to EUR 1.8tn instead of 1.2tn
Thanks Bill. I think you are right, I will check.
Hi Eric, I read this on my Twitter stream (see below) today. From my simple understanding of Draghi’s dual interest rate policy, I thought the idea is to ensure deposit rates are positive and lending rates negative.
This seems to indicate otherwise – could you explain?
Thanks,
Gary
“Berliner Volksbank, the country’s second-largest cooperative lender, started to apply a minus 0.5% rate on deposits exceeding 100,000 euros”
So this is where negative rate policy starts to go off the rails, when people start calculating the cost of losing money on their deposits vs digging holes in the ground to store the cash.
bloomberg.com/news/articles/2019-10-07/german-lenders-drag-retail-clients-into-fray-of-negative-rates…
Hi. Can we translate, credit you and re-publish this in Spanish here: dolarizacion.ec ?
Sure. Thanks. Eric
Eric,
Have been reading your work on monetary policy for a little while now and have to offer thanks for elucidating some important issues.
That said, I’m not yet convinced about the macro utility of a dual interest rate regime. The upshot of all unconventional monetary policy – whether QE, negative rates, or dual rates – seems to be injecting liquidity into the system while simultaneously encouraging bank lending. But this is an oblique response to the problem, which is a decline in investment and growth due to low expected profits. As we’ve seen the effect of QE was to incentivize incredibly risky lending and a shift into risk assets while failing to fundamentally restart growth in the developed economies. And the price of this was a policy that dramatically inflated asset values into new bubbles that cannot safely unwind.
What does subsidizing bank profits through dual rates do that other forms of unconventional monetary policy cannot? The strategy of printing liquidity into existence in hopes of spurring lending is the same. It’s hard to see how, even if the policy succeeding in temporarily boosting capital spending, the end result would not be significant inflationary pressure ultimately threatening confidence in the particular currency. As far as I’m aware in the U.S. this was only avoided with QE thanks to the IOER facility.
If the problem is private profit-driven investment running out of steam, isn’t a switch to public investment a much clearer response, rather than continuing to push on the string of monetary policy? Thanks in advance for your time.