The textbooks argue that conventional monetary policy loses traction when interest rates are close to, or below, zero. Central banks have thus experimented with policies such as quantitative easing and forward guidance. Yet, Japan and the Eurozone have negative rates and retain faith in the traditional effectiveness of interest-rate changes.
Cash, with a zero nominal interest rate, makes negative interest rates conceptually problematic. Cut interest rates too far into negative territory and customers might withdraw deposits and banks would lose funding for loans. The existing banking system would be destroyed.
And if banks chose not to pass on negative rates to retail clients yet cut their lending rates in line with central-bank policy, their profitability would be squeezed, again reducing lending capacity.
True, Eurozone banks have imposed negative rates on corporate depositors, incentivising companies to invest. But what if other forces – such as a pandemic – reduce aggregate demand? The squeeze on bank profits would be reinforced by lower economic activity and bad debts, further limiting lending and undermining the mechanism for transmitting monetary policy.
And if commercial lending rates do not fall in line with ‘official’ rates – making interest-rate policy toothless – rate cuts may provoke perverse effects. Many Swedish companies even paid their taxes early rather than watch their bank balances slowly shrink.
While the aim of low interest rates may be to encourage borrowing and discourage saving, they mean anyone investing for old age needs to save more (or take more risk or retire later) and that pushes interest rates even lower. With sub-zero rates, monetary policy may cause a ‘reverse stimulus’.
Abolishing cash might be a solution. It was on the wane even before the pandemic. Yet if only one country does it, citizens could seek alternative currencies or stores of value such as gold.
Another solution might be dual interest rates. If commercial banks can’t or won’t impose negative interest rates on retail depositors, central banks could provide finance at negative rates on condition it is re-lent to the wider economy – as the European Central Bank already does. But would the central bank have to determine which commercial loans were justified? Before long, open financial systems could be replaced by a structure more in keeping with Soviet-style state planning.
Yet another option is to control the supply of money rather than the price. The central bank ‘buys’ government debt and the government uses the cash to cut taxes – ‘helicopter money’ – or increase public spending. But not only could this compromise central-bank independence, it works primarily by increasing inflation, and if people spend to avoid future price rises, they risk unleashing the inflationary outcomes they fear.
A better solution might be to boost the economy through fiscal policy rather than monetary measures. COVID-19 shows how far governments can go beyond the limits of conventional fiscal borrowing rules. Investing in green infrastructure is one option.
It may be time for central bankers to declare that monetary policy is reaching the point of impotence. With luck, the return of positive interest rates – thanks to successful fiscal stimulus – might allow them to regain the pivotal role in economic affairs that they have slowly been losing since the Global Financial Crisis.
First published 23November 2020.
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