Scott Sumner: Insightful analysis
Seriously, lets all go and read Scott Sumner. He discusses how monetary policy can still be effective even when the cash rate hits zero, and I find it difficult to fault his reasoning.
I would suggest reading all the posts, but there are a few that touched me:
This one: I agree that some people think we are going to have hyper-inflation or deflation simulatenously – usually without even realising why we target inflation 😛
A short course on monetary theory: Useful historical breakdown.
Calling out the Fed: Key quote for me is
Under Hall’s proposal, the Fed would now be paying a negative rate (i.e. charging a penalty rate) on excess reserves
This was the first time I had ever seen the idea of penalty payments on reserves – and to be honest I love it. I realise that the authors first choice is having a central bank commited directly to a nominal GDP target – but I see penalty interest as something we can introduce more immediately in the current environment.
Finally, my favourite post (which is more methodology really) is this. It illustrates a major issue in the discipline – namely the vagueness of the implicit models economists sometimes use when discussing policy. It reminds me of the “rhetoric” argument of McCloskey – a good critique of the way economics IS DONE (which is different to the argument around how economics SHOULD BE DONE mind you, when it comes to this issue I don’t agree with McCloskey).
Thanks Matt, It is very gratifying to have people read my blog. Only one comment. I think the interest penalty on reserves could compliment NGDP targeting, make it easier to hit the target. So I don’t see it as an either/or proposition.
@Scott Sumner
Its good clear insightful stuff – I had to recommend it 🙂
Very true about the policies being complements. I was really just saying that I think our current bank would find it easier to implement a charge on reserves than making a NGDP target – as I see the idea of a charge on reserves in the same light as a negative cash rate, something central banks seem unwilling to look at.
How would that work here Matt? My knowledge of the banking system is woefully out of date, but from memory there isn’t a required reserve ratio is there? In that light how would we define the excess reserves that banks will be charged on?
Don’t get me wrong I think it sounds like a good idea, but to implement it here would the RBNZ need to implement reserve ratios?
I’m assuming they haven’t done so since I was tutoring ECON 130 and telling my students that there is no reserve ratio, this may be a false assumption:)
@agnitio
No you are completely right. But in NZ you could just charge interest on all Reserves – or set a reserve level under which you don’t charge interest. The bank’s have to tell the RBNZ their reserve level, so it will work a treat.
I sort of see it as follows. The RBNZ sets a negative OCR, so they pay some level on interest on bank borrowing – and charge a larger penalty rate of interest on bank reserves. In this case bank’s won’t borrow from the RBNZ and then put it in reserves – as it is costly.
The banks then have to lend the money out or buy bonds – either way it “injects money” into the economy. Voila.
How it would work here is that the payments system would fall over in a matter of days, then the Reserve Bank would remember that the problem here is a shortage of cash, not an excess of cash sitting idle.
@Miguel Sanchez
A shortage of cash you say – in what way? If cash is sitting in reserves there is a “shortage of cash” for transactions – which is exacerbated by the money multiplier. A negative OCR just provides a disincentive for holding reserves.
Currently I agree we have no need of a negative OCR – but that doesn’t mean there isn’t potential for such a situation.
The hard thing is identifying “reserves” – as there is no way in hell that banks will hold much in RBNZ accounts if they are getting pinged on it.
In our system, bank balances at the RBNZ are no more than what’s needed to settle interbank transactions in real time. Create a disincentive for banks to hold that cash, and the payments system will start to gum up pretty quickly.
By the way, the RBNZ already charges (or pays a lower interest rate) on what they estimate to be “excess” reserves.
@Miguel Sanchez
In a normal situation yes – but the purpose of a negative OCR is to work in a pretty exceptional situation.
I would also note that a negative OCR implies that the RBNZ will PAY banks to borrow – so that can be used for interbank balances if needs be.
The problem is that it’s precisely the wrong solution for NZ’s situation. US banks have an asset problem: they’re unwilling to lend because there are no credit-worthy opportunities out there. They’d rather take a guaranteed return of zero than invest in an uncertain but probably losing propositon.
NZ banks have a liability problem: they’re willing to lend, but are struggling to find the funding for it. If the RBNZ starts paying banks to borrow, they can expect to end up funding the entire banking system through what is ostensibly a liquidity facility – the RBNZ might be happy to lend at negative interest rates, but depositors and wholesale lenders certainly won’t be.
@Miguel Sanchez
I agree that in New Zealand’s situation we don’t want to go down this path right now. In the situation where we don’t have a credit constraint (which we don’t) the primary purpose of a negative OCR is just to increase the quantity of money in circulation.
With no additional lending (which I don’t think is a give-in) banks could still buy bonds to reduce “reserve holdings”. In this case a negative OCR would merely push banks to borrow off the RBNZ to buy bonds – which is equivalent to quantitative easing.
If we hit an OCR below 1% – which is a tail situation – we need to think about exactly how we can use monetary policy to stimulate the economy. A negative OCR is more appealing to me than straight quantitative easing as it is likely to end up with at least some additional lending.
“NZ banks have a liability problem: they’re willing to lend, but are struggling to find the funding for it”
Indeed – which is why nominal interest rates can be held up even as the OCR falls. There is nothing we can really do about that – but at least by printing money (which is what a negative OCR is) and showing that we mean business when it comes to a stable rate of inflation we can prevent deflation.
Of course, with M3 growing at over 10%pa I don’t see much risk of deflation – but it is still something worth keeping in the back of our minds.
Note that this is also not something I would be keen on if the rest of the world isn’t doing it – as it would impact on our ability to get international funding. But the fact is that a lot of the rest of the world is in a situation where they are looking at quantitative easing – and so it is at least something we should analyse a little.
“RBNZ might be happy to lend at negative interest rates, but depositors and wholesale lenders certainly won’t be”
Nominal interest rates cannot be zero – agreed. But this isn’t the purpose of a negative OCR. Fundamentally it is one way of increasing the quantity of money when nominal interest rates are close to zero – that is the purpose of the policy. It is just like quantitative easing – but instead of having governments buying bonds we have banks either buying bonds or lending out some value of their reserves/money they are borrowing from the RBNZ.
My last point is about the rates that banks would need to lend at. Let’s say they can fund a quarter of their balance sheet at a negative OCR, say -1%, but the other 3/4 is funded by deposits (because there will always be deposits somewhere in the system) at say 2%. Their average cost of funding will then be 1.25%, and with their margin added on top (including a big whack for bad loan provisions, since we’re talking about a disaster scenario here) they wouldn’t be able to lend at anything less than say 4%. My point is that this method will only get traction to the extent that the central bank is willing to displace the private sector in funding the banking system.
@Miguel Sanchez
Indeed. However, the goal of the policy isn’t to change nominal interest rates – it is to increase the quantity of money in circulation thereby reducing real interest rates. By getting banks to buy bonds, the RBNZ is increasing the quantity of money in the economy.
If we need to “create inflation” in the economy this is one way to do it. However, the external funding issue is still very important – as if we look like we are trying to hyper-inflate ourselves out of debt they will ditch us. Even so – if the negative OCR is just an attempt to achieve the RBNZ’s explicit mandate to have a 2% rate of inflation I don’t think we would face this – and as a result, it is just a method the RBNZ can use to credibly achieve its mandate.
Nominal interest rates will definitely stay positive – it is impossible to make them negative. However, this isn’t the goal …