The latest speech by the RBA’s Governor Philip Lowe, they have ruled out negative interest rates as an alternative monetary policy option for Australia in the near future.
In the discussion, the RBA outlined the cost side of this tool, namely “They can also encourage people to save more, rather than spend more, so they can be counter-productive from that perspective too.”
I would like to discuss this further as it is contrary to how we often talk about monetary policy, and fleshing it out helps to make some of the assumptions made clearer.
How do negative interest rates work?
First of all, let’s shed some light on what are negative interest rates and how they work.
I have already discussed negative interest rates as policy here:
“The first solution to this problem is to try to set the interest rate to its appropriate negative neutral level. This isn’t the idea that savers pay lenders – as we aren’t really talking about their interest rate – but it is with regards to the cash rate. The cash rate sets the interest payment/fee for retail banks in their settlement cash accounts.”
By setting the cash rate lower and thereby pushing down interest rates in the economy, the central bank tries to boost demand in the economy – helping to lift both activity and inflation in a situation when both are below target/potential. Specifically, as interest rates fall households and firm increase their expenditure/demand. This helps to moderate recessions, by cancelling out a drop in expenditure due to some underlying cause (uncertainty, animal spirits).
Assuming that a lower cash rate does lower interest rates, then the increase in expenditure is coming from consumers and firms spending more due to interest rates falling – hence if consumers and firms responded to the change in interest rates by initially saving more (spending less) this would fundamentally undermine the efficacy of the policy change.
Back to the Governor’s saving point…
As a result, it is worth spelling out the logic of how negative rates “…can also encourage people to save more…”.
A change in the interest rate has income and substitution effects – a lower interest rate incentivises spending now, as you receive less in the future from saving $1 (substitution effect).
However, if you are a saver and have a “target amount” you want in the future, a lower interest rate might incentivise saving now – as you have to save more now to have that amount in the future. Another way of saying this is that a lower interest rate reduces the lifetime income of a saver – and so that reduces their consumption now (and thereby increases their savings).
Normally we view the substitution effect as dominant in an aggregate economy, as the income effects cancel out between individual savers and borrowers (as the income effect will boost consumption now for a borrower). However, the RBA may believe that – at a negative interest rate – the responses will be asymmetric. Borrowers will refuse to increase their consumption now, and saver will cut consumption strongly now in order to keep their “target” of future income. As a result, aggregate savings could rise.
However, is there any evidence for this? And why does this channel only become relevant at a zero interest rate, surely the asymmetric responses of savers and borrowers could be seen as relevant at any interest rate – even very positive interest rates.
Often we will look past the implications for savings because saving propensities are relatively invariant to the price (interest rate) while lending is responsive – and in turn determines demand. Why would saving propensities suddenly become so much more responsive when the interest rate becomes zero?
Savers hoarding cash
It is also important to note that this mechanism is different from savers hoarding cash – which is a situation that changes significantly when interest rates near zero. The savings argument above assumes that negative rates ARE passed through, and that household and firm behaviour is different – but there is an earlier question of whether a negative cash rate is passed on at all.
If savers were to hoard cash instead of accepting negative deposit rates, then that would prevent banks from passing the lower cash rate in terms of borrowing rates. Why? Because their inability to cut deposit rates implies that they need to continue charging a higher lending rate to make the same margin.
As a result, hoarding does influence the pass-through of a negative cash rate (and the ability for negative interest rates to practically occur) but it is not related to the idea that saving will rise with negative rates.
Furthermore, with regards to cash hoarding negative rates haven’t been as problematic as was anticipated (at least in the short-term).
This paper from the ECB found no evidence that the negative interest rates incentivises households to hoard cash. While the other evidence shows the opposite relationship, where firms get penalized by cash hoarding, hence why they tend to lend out more.
Overall, although the RBA piece makes some excellent points I think they oversell the weakness of negative interest rates as a monetary policy tool.