Negative nominal interest rates were an interesting theoretical construct. The mental exercise is as follows: to encourage consumption, a central bank can resort to negative (technically, just low, but we’ll ignore that for now) real interest rates. Because the real return on capital is negative, it’s better to spend money on investments or durable goods than to save money. However, when deflation sets in, even a nominal interest rate of zero can be quite positive in real terms. As a consequence, economists play with the idea of negative nominal interest rates as a means of achieving low/negative real interest rates. And, just so we are clear, putting a negative interest rate on loans doesn’t really work because people can simply borrow as much as they can and sit on it. That’s of no interest (pun!). Instead, economists are concerned with a negative interest rate on deposits. For bank reserves, this would encourage banks to lend. For normal deposits, the idea is that it would encourage people to spend. Unfortunately, it could also just cause a run on the banks, as simply holding currency prevents the erosion of savings. When discussed in an academic environment, negative nominal interest rates often goes along with the abolition of physical currency. Electronic currency could carry a time stamp for all debits so that the value erodes over time. Anyway, I always thought of it as a purely theoretical exercise. Last week, it became reality.
The Swedish central bank (Riksbank) set a negative deposit rate of -0.25%. This means that bank reserves are penalized. At first, I heard about this via Mish. I looked at the press release, and sure enough, it was there. I thought it was a typo. The Riksbank issued a report (pdf) at the same time. Sure enough, the report contains an article titled “Monetary policy when the interest rate is close to zero.” When I saw the same news on naked capitalism, I realized that it was more than a typo. The Swedish central bank had actually gone insane. What I find really bizarre is that the Riksbank knows this. In the article, they discuss some of the potential consequences:
Two such circumstances have, above all, been highlighted in the recent discussion. The first is that really low policy rates may have a negative impact on the profits of the banks or make them less willing to allow policy rate cuts to be reflected in the interest rates they offer to households and companies. The second is that there is a risk that some parts of the financial markets will begin to function less effectively at lower interest rate levels. In the background there is also perhaps the most dramatic consequence of the interest rate being too low: That companies and households choose to withdraw money from their bank accounts and instead choose to retain large amounts of cash.
The banks’ deposit rates are normally lower than the policy rate and will therefore reach zero before policy rates do. Given that the banks feel that they can not reduce their deposit rates below zero, their margins – the difference between the deposit rate and the lending rate – will fall as the policy rate is reduced. Moreover, the banks’ cost for borrowing from the central bank are higher than the policy rate, as they must provide collateral for these loans. Lower margins have a negative impact on the earning capacity of the banks and risk reducing the willingness of the banks to lend in a situation where this willingness is probably already low. Alternatively, the banks may choose to maintain their margins by not allowing lending rates to fall along with the policy rate. In both cases, the cut in the policy rate has less of a positive effect on the economy than would otherwise be the case. An additional alternative is that the banks, to the extent that this is possible, adapt their charges for deposit accounts and banking services in a way that in practice entails a negative interest rate.
So, what will happen? It appears that the central bank is counting on banking fees disguising a negative nominal interest rate from the customers. This isn’t necessarily the goal. Really, the central bank is hoping that the banks will lend more to reduce their reserves. This is also a scary prospect. Banks in Sweden have just as big a problem with maintaining adequate capital as the banks in the US. Perhaps the convenience of bank accounts is worth a negative interest rate. This is also discussed in the article. However, such a convenience is a liquidity preference, and is likely subject to a limit. I still pay my rent and a few bills by check, so a few thousand dollars in a checking account would be sufficient. The rest would be stored in a mattress (or money market account, or foreign bank, etc). If this is the response by the Swedes, it could be disastrous for their banking industry.
Central banks are clearly desperate to be resorting to such risky policy measures. We are fortunate that the Swedes are trying this experiment before Bernanke and friends.
