Dual interest rates always work

The future of monetary policy – Dual interest rates

The significance of dual interest rates remains under-appreciated. The European Central Bank, Bank of Japan, and the Bank of England’s facilities are by far the most significant policy innovations since the financial crisis. Curiously, most of the economics profession and commentariat seems oblivious.

Firstly, what are dual interest rates? Economists love obscuring important policy innovations with (often inaccurate) semantics. So let’s make this clear. As Martin Sandbu points out, central banks have always had more than one interest rate. Typically, they have an interest rate which they pay on bank deposits held at the central bank, and a rate at which banks can borrow electronic cash (‘reserves’) from them – often at ‘punitive’ rates. Typically we pay little attention to these different rates, because policy has a single goal – to influence money market interest rates, which are the benchmark for lending and deposit rates throughout the economy, and influence asset prices. For technical reasons the effective policy rate can vary, but at any point in time, there is typically only one. In the Eurozone it is currently the ‘deposit rate’, in the US it is the ‘fed funds target rate’.

I am defining ‘dual interest rates’ as a policy where the central bank tries to separately target an interest rate on bank lending and the interest rate on bank deposits. The traditional constellation of rates does not attempt to do this. Why does this matter? A single interest rate policy – one aimed at targeting money market interest rates or bond yields – has ambiguous economic consequences. This is at the heart of the problem with negative interest rates. In a single rate world, a decline in interest rates leaves the net income of the private sector unchanged – for every borrower who has higher disposable income because interest rates have declined, there is a deposit holder who has lower interest income. In reality, this is complicated by taxes, and financial intermediation, but the essential point holds (Warren Mosler makes a similar point, here, regarding the effects of QE).

Given that a fall in interest rates typically leaves private sector net income income unchanged, textbook economics requires other processes to create a stimulus – for example that the marginal propensity to consume of borrowers is higher than savers (Miles Kimball has written extensively on this). But these effects are entirely contigent – they do not necessarily hold – and there are good reasons to believe that sometimes the effects are the opposite.

That is why dual interest rates are monetary rocket fuel. A system of dual interest rates can necessarily raise the net interest income of the private sector, and can create large, predictable demand for new lending. To make this clear, consider a situation where the ECB raises its deposit rate to zero (it is currently -0.4%). This interest rate is paid on bank deposits held with the central bank (reserves), and will cause money market rates to rise. Typically, this will cause deposit rates across the Eurozone to rise, and also some interest rates on loans. Simultaneously, the ECB offers a new lending facility to banks at -1% fixed for 5 years. To clarify the power, let’s assume the facility is equal to 20% of Eurozone GDP. The conditions for the loans are that they be additional credit and banks must illustrate that borrowers receive a significant share of the reduction in funding rates (say 50 basis points).

There is little doubt that this facility would be taken up in full, because a huge range of investment opportunities are highly profitable at a -1% fixed over five years, and the stimulus is two-fold. The net interest income of the private sector rises, and there is a large increase in lending. Of course, if -1% doesn’t do it, the ECB can cut the rate further and extend the term further. There is no economic model where this type of policy does not generate demand, cause unemployment to fall, and ultimately prices to rise. Dual interest rates, the ECB’s TLTRO being the clearest example, is a huge breakthrough in monetary policy. There is no excuse for any central bank saying they have run out of ammunition and there is no reason why any central bank is failing to hit their inflation target.

It is worth outlining the superiority of dual interest rates to the existing ‘innovations’ since the financial crisis. Forward guidance has all the weaknesses of standard, single rate-based policy. It simply extends the reduction in the single rate out to longer horizons. QE is highly effective when there is a reserve shortage, but once money market rates have collapsed and banks hold huge excess reserves, its effects diminish. The effects of conventional monetary policy suffer from diminishing marginal impact. Dual rates, by contrast, become marginally more powerful: consider a TLTRO at -5% for 20 years, or a perpetual TLTRO at -1% (a combined helicopter drop and a basic income!).

The mystery at this point is the negligence of the global economics community in ignoring the significance of these policy developments. There are a very small number of exceptions, including Megan Greene, Simon Wren-Lewis, Martin Sandbu, and Miles Kimball. Most US policy economists seem to think asset purchases and forward guidance are the only game in town, as the opening speech by Jerome Powell at the Chicago Fed conference on new tools for the Fed illustrates.

The failure of central banks globally to provide overwhelming stimulus to demand and meet their inflation objectives is no longer accepted and should not be tolerated. The first step, as always, is cognitive.

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

8 Responses

  1. Marco Saba

    Yesterday I called my bank in Denmark, Nordea, and couldn’t believe what they told me…
    They offered to lend me money at MINUS 0.12% for a ten-year mortgage.
    In other words, the bank would PAY ME to take out a loan. None of this makes any sense.
    Here in Europe, bank deposits yield close to 0%.
    In 2016, the Swiss government even asked its citizens to delay their tax payments as long as possible, because the government didn’t want to pay negative interest rates on those balances.
    And in the United States, banks rob their customers blind time and time again by lying, stealing and deceiving them.
    It’s extraordinary to me that these are the options we have with our money today.

  2. JKH

    Just came to this via twitter.

    It’s a common view that Treasury deficits deliver net financial assets and wealth and stimulus to the private sector. That’s been hammered home by MMT and others. Treasury does that using bonds.

    What you are arguing for in effect amounts to the same approach for the role of the central bank – i.e. the Central Bank should be able to choose freely to run deficits as it deems appropriate and deliver the same type of wealth effect using money.

    That’s obviously an upheaval in the overarching framework for fiscal and monetary policy.

    I think it’s also interesting that the current role of the central bank is captive to the discipline of running a balance sheet that “balances” in the sense of the normal condition being positive equity and positive profit (notwithstanding NIM risks such as QE). It resembles private sector discipline in that regard. The Treasury balance sheet is subject to no such discipline.

    So another way of putting the question might be – why the need for that overarching asymmetry?

  3. Michael Joffe

    I am not a monetary economist, my work concerns the real economy. So maybe this is naïve. But can Eric Lonergan, or someone else, explain why this is not true?

    What is proposed is a subsidy, or indeed a gift, from the central bank to commercial banks. It would undoubtedly be popular among the commercial banks for this reason. The result of the policy would be to flood the financial system with money. But what would happen then? – do we really expect lending that will be economically beneficial, on a large scale? The experience with QE (which has the same feature of flooding the private financial sector with money) has been that the result is mainly a rise in asset prices. It may well be true that “There is no economic model where this type of policy does not generate demand, cause unemployment to fall, and ultimately prices to rise”, but that may be a problem with the assumptions of these models. Eric Lonergan’s division of the economy only into the public and private sectors obscures the arguably more important division between the financial sector and the real economy.

    • Eric Lonergan

      Targeted loans have conditions. I would attached conditions to these lending schemes – such as regional investment or sustainable energy. Also, there is no reason why the bank needs to make all the margin. The central bank could necessitate evidence that it is being passed on to borrowers. If the Bank of England can do a ‘help to buy scheme’, why not a ‘help to make the planet sustainable’ scheme?

      • Richard Crowe

        I am no economist but I thought that the original aim of QE was to encourage the commercial banks to lend but that in the event they were not doing so to any great degree but rather merely repairing their balance sheets and improving their reserves. If this was the case then how would you ensure they invest or lend for investment more effectively than was the case with QE?

      • Eric Lonergan

        You would attach conditions to the lending. For example, you (the bank) can only borrow at -1% for 10years if you make a new loan which finances investment in renewal energy.

  4. Michael Coughlan

    Has anyone done any mathematical modelling of this (written down a few equations)? It just strikes me that like almost every other policy there must be some edge case where it does actually fail. Also is there an underlying assumption of a minimum growth rate over the long term to finance the difference between the rate of interest on loans and the rate on deposits – or is the idea that the central bank just prints money to cover it? Or am I misunderstanding completely?

  5. Kevin Carney

    In a central bank dual interest rate setup, where depositors are paid a modest rate to leave deposits and borrowers are paid a higher rate to borrow, what prevents an investor from borrowing a bunch of money from a central bank, depositing it in their central bank account, and pocketing the interest rate spread?

    It seems that would be free money to the investor, but it wouldn’t solve the fundamental problem, which I believe is to stop money from being parked and get that money flowing through the economy.


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