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Negative Interest Rates? huh!

Reposting a mail from the very initial days of PFPAC on the concept of negative interest rates. This would not only give a wider exposure to the concept, but would also help in developing it at a later stage. 

Recently, Bank of Japan (BoJ) introduced a Quantitative and Qualitative Monetary Easing (QQME) with Negative Interest Rates. Whats the logic behind this other than maybe reducing reserves to induce banks into lending more? Tricky and audacious at the same time. The seven-pager document (here; Caution: pdf) isn't a rigmarole, but the underlying logic sure is a Rube Goldberg machinic one, and that too in the face of impeccable liquidity management at the operational level at the Bank, where near zero-interest rates amidst growing fiscal deficits were carefully held. When Japan initiated its Quantitative Easing (QE) in the early 2000s, the rationale was to flood banks with enough liquidity to promote private lending leaving them with humongous stocks of reserves and scarcely a risk of liquidity shortage. this was achieved by buying excess amount of Government bonds than would be required to set the interest rate to zero. But, this stimulating package only accomplished a moderate success rate on the performance scale, to say the least. The banks are not reserve constrained in their lending, and thus the only rationale behind the stimulus as a result of negative interest rates would be investment and consumer durable were motivated enough to borrow at lower interest rates that the asset swap (bonds for reserves) generated. 

According to the official communique, QQME with a negative interest rate would achieve the price stability target of 2% at the earliest; Adopt a three-tier-system to map-out outstanding balance of each financial institution's current account at the bank; Introduce Money Market Operations (MMO) (Caution: pdf) to swell the monetary base by ¥80 trillion annually, and thus go in for more Quantitative Easing; and Adopt a Qualitative Easing goal by exchanging a broad range of public and private assets for reserves. In line with Point 3 on Page 3 of the document linked to above, it is maintained that the BoJ will lower the short-end of the yield curve by slashing its exposit rate on current accounts into negative territory and will exert further downward pressure on interest rates across the entire yield curve, in combination with large-scale purchases of Japanese Government Bonds. This is where Negative Interest Rate (NIR) find itself defined: Imposing tax on banks for holding reserves above certain limits with the BoJ. The logic cuts across smoothly here, for banks will not show readiness to borrow from each other at higher rates, and implying subsequent pushing of longer-maturity rates down. The dressing up logic, however is to address global volatility in markets with a double-edged sword of imposing public tax on private sector to promote exhilarating inflation. With a moderate success the first time QE was taken up, what guarantees bad implications for earnings of financial institutions slipping into the negative territory? In response, BoJ claimed, "overcoming deflation as soon as possible and exiting from the low-interest rate environment lasting for two decades is essential for improving the business conditions for the financial industry."  

Helter-Skelter midstream!!! But, there are more layers to peel to get centric. Okay, what is the three-tier-system about? 

Tier-1: pays a +ve 0.1% on Basic Balance covering existing reserves traced on the system from previous QQME. 
Tier-2: The Macro-"Add-on" Balance receiving a zero interest, and helping maintain required reserves held by financial institutions subject to Reserve Requirement system. 
Tier-3: Policy-Rate Balance with a -ve 0.1%, with provisions of new reserves entering the system, with a tax of 0.1% on the bargain. This is where Tier-3 gets muddled. The logic is to swell reserves notwithstanding the fact that bank lending reserve constrained. 

According to Bank of International Settlements' Unconventional Monetary Policies: an appraisal (here; warning: .pdf file), such unconventional monetary policies are distinguished by central banks actively using its balance sheet to affect directly market prices and conditions beyond a short-term, typically overnight interest rate, and referring to such policies as "balance sheet policies" rather than "interest-rate policies". Hereby, they obliterate insights understood in the Keynesian period by taking recourse to a decoupling principle via which the central banks remunerates bank reserves relative to the policy rate. Quoting in full, 

..key feature of balance sheet policies is that they can be entirely decoupled rom the level of interest rates. Technically, all that is needed is for the central bank to have sufficient instruments at its disposal to neutralise the impact that these policies have on interest rates on any induced expansion of bank reserves. Generally, central banks are in such a position or can gain the necessary means. this "Decoupling Principle" also implies exiting from the current very low, or zero interest rate policies can be done independently of balance sheet policies. 

The principle is congruent with Modern Monetary Theory, or MMT in short, where Central Bank can sell Government debt in order to adjust the quantity of reserves to bring about desired short-term interest rate; or remunerate execs reserve holdings at the policy rate setting the opportunity cost of holding reserves for banks to zero. This then delinks the interest-rate level set by the central bank severing any relation between swelled-up reserves and interest rates. The BIS paper sums this up, 

In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending...The preceding discussion casts doubt on two oft-heard propositions concerning the implications of specialness of bank reserves. first, an expansion of bank reserves endows banks with additional resources to extend loans, adding power to balance sheet policy. Second, there is something uniquely inflationary about bank reserves financing. 

This falls in line with MMT's basis premise that banks reserves are not required to make loans and there is no monetary multiplier mechanism at work. BIS paper then starts hammering the nail in the coffin by invoking the ghosts of past Japanese experiments with QE, 

A striking illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan's Quantitative Easing policy from 2001-06. Despite significant expansion in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.

Japanese banks are not expanding credit as a result of unwillingness to make loans or a lack of reserves. Instead, the reason for slow credit is that businesses have sufficient capital stock to satisfy the demands of a very weak consumption sector and hence do not feel the need to borrow. 

Negative interest rates will not alter that, since perhaps holding on to cash as a liquidity measure to transcend time as uncertainty is the future DOES.



Comments

  1. Central banks across the globe are trying a radical approach to boost economic growth: negative interest rates. But what are negative rates and will they work? https://pfpacjournal.blogspot.in/2016/06/negative-interest-rates-huh.html#comment-form

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