From a negative OCR to negative interest rates …

Earlier we discussed a negative OCR as a way to push us towards the “zero bound” on interest rates.

But Greg Mankiw has brought up an interesting point – what happens if we want negative interest rates?

Mankiw admits that we could have a lottery scheme where some currency gets knocked out of circulation randomly – making the return on currency negative. However, he comes up with an interesting point if we just wanted to lower interest rates through a negative OCR.

If reserves earned a negative return at the margin, banks would have more incentive to lend (which is the motivation for these proposals). But more lending might not be the outcome. Banks could instead discourage deposits by, for example, passing the reserve fee on to depositors. Deposits would then earn a negative return, which would give households an incentive to hold currency rather than bank deposits

If the return goes negative for banks they may just pass it on to households who will “horde currency”.

However, I have to ask – will household’s just hold currency as savings? Maybe they will go out and buy bonds or gold or copper – or any sort of durable asset which could double as savings. As long as the asset holder will spend some of the money – then the final impact of the negative OCR will still be stimulatory (either for prices or output depending on your view of the world).

Its like a hot potato situation – banks don’t want to lose money on reserves so they don’t take deposits and charge a negative interest rate, households don’t want to accept a negative interest rate so they buy assets driving up asset prices, the ex-asset holders have cash which they spend.

Now it is possible that households won’t do this, and they will put all the money under their bed – but I just don’t buy it. Not when there are other savings vehicles that will offer a positive rate of return.

By paying the banks to borrow money from the central bank as well, we will get them to go out and buy bonds and the such – doing the same jazz.

Note: Whether we SHOULD do this is a whole other question – the only purpose of this post is to discuss if we CAN do it. There is a world of difference …

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  • rainman

    I’m with Mish on this one:

    Sounds like a dumb idea to me. But then again, I’m a responsible saver, so not overjoyed at the race to zero when it comes to rates.

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  • @rainman

    Hi Rainman,

    I don’t agree with Mish overall. However, economists have to be careful in saying why they think interest rates should be negative – as that is a lot of loosening!

    Mish is right that the goal is to “generate inflation” – but this is in an environment where the price of goods are falling while wages are “stuck”. This leads to unemployment – and the relationship between firms, workers, and government prevents a sufficient decline in wages.

    When employment falls, production itself drops further, lowering real income in society.

    So the thinking is, if we can “inflate” the price of goods, we can prevent the unemployment that stems from wages being stuck.

    It is a simplistic version of the idea – but that is the general idea. In the US there is a fear they are heading down a path that needs this – in the GD they did need it as unemployment (which is a “surplus of labour” and so is a market failure – although note if unemployment is around or below 5% we don’t see it this way) hit 25%.

    For NZ this seems unnecessary – but the concept and ideas are still important to discuss.

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  • Miguel Sanchez

    But if households really did have “other savings vehicles that will offer a positive rate of return”, it begs the question: why wouldn’t the banks be putting their money into the same vehicles?

  • @Miguel Sanchez

    Exactly – they do. They buy bonds and the such, pushing up the relative price. It works in the same way as the Fed coming out and directly buying bonds – except we get some idea of the type of risk households and banks are willing to take on

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  • JD

    I’d damn well put it under my bed.

  • @JD

    But to what level – if the government dropped $100,000 into everyone’s lap, would we all keep it under our beds …

    It doesn’t makes sense to say that we can’t make real interest rates negative – and if needs be we might be able to throw the money in by making nominal interest rates negative …

    If that doesn’t work – the army owns helicopters, and our postal service still functions 😉

  • Miguel Sanchez

    @Matt Nolan
    But then what do the banks buy the bonds with, since they’re presumably not attracting deposits? They’d have to get more and more of their funding from the central bank.

    This is the point I was getting towards in the previous discussion: negative interest rates are doable, but only in conjunction with quantitative easing; they’re not a substitute.

  • @Miguel Sanchez

    Well, they are sort of like QE – except you get some price signals.

    QE is like a negative OCR in the same way that a increase in the standard OCR is like cutting the money supply …

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