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.