ECON141: When cash rates go negative

Last time I discussed how the cash rate influenced the interest rate.  But what happens when the cash rate goes negative?  This is the focus of today’s post.

After recent discussions about “negative interest rates” across Australasia I thought it would be useful to talk about how these rates appear mechanically at a high level (in terms of financial system operations).

In class (and Gulnara’s posts here) the motivation of why negative interest rates might be appropriate in a policy sense was raised.  Furthermore, she did a great job of noting that it is unlikely that negative rates will cause additional savings (as some have claimed) and so theoretically we can continue to think about our investment model with negative interest rates.

For this post we will assume that the central bank is trying to influence interest rates towards a level that will “close the output gap” or “push Y to its sustainable level” and achieve their inflation target, and it just happens that this interest rate is negative.

The wrinkle is that we achieve this negative interest rate through a settlement cash mechanism – so we need to ask, how do negative rates in settlement cash accounts translate into lending and actual interest rates?

Negative rates and settlement cash

Let’s take our example from before and assume that the OCR is cut by 400 basis points to -2%.  In this case the borrowing financial institution will “pay” -1.75% and the depositing financial institution “receives” -2.25%.

Why would an institution deposit funds in an account to earn -2.25%?  Why would financial institutions not just ramp up their borrowing at -1.75%?

The reason for that intuition we feel is that we are thinking about money – money yields a nominal interest rate of 0%.  If the banks could just independently hold money at 0% they would borrow endlessly at -1.75% and would never save at -2.25%.  

However, the settlement cash account is designed to include cash holdings for banks.  So if a bank borrows a dollar from settlement cash and tries to hold it as a cash asset, it returns as a deposit in the settlement cash account.  So in this way the system cannot be escaped.

What about interbank lending?  One bank could lend to another bank at 0% and this would be a better return for the lender than -2.25%.  But that bank who is borrowing is paying 0% instead of -1.75% is actually worse off.  As a result, the interbank market will reinforce this dynamic as long as the settlement cash account is determining the opportunity cost of marginal lending.

Given the banks cannot avoid these negative rates in settlement cash accounts, they would then be expected to pass these on to both their depositors and borrowers (in order to achieve the same interest margin) through lower/negative interest rates!

However, they haven’t been. Deposit rates refuse to budge below zero in countries with negative cash rates, and although banks are accepting lower margins they have also reduced lending rates by less than they would have otherwise.

In this situation, there are two ways that banks can turn around and try to avoid these negative rates – and therefore avoid passing on negative rates to depositors and lenders:

  1. Investing in instruments that are zero yielding that don’t get captured in settlement cash (eg overpaying tax – e.g. Sweden).  We need to be careful here not to include assets that have an expected negative capital gain (as that equates to a negative yield – such as gold).
  2. More carefully ensuring that deposits and loans match on a day-to-day basis.

Both of these have one thing in common – banks are willing to slow down their matching of lending and borrowing, and accept lower liquidity, in order to avoid the cost associated with negative interest rates.

If this is the case, then when rates become negative enough (when they aren’t just representing a small service fee) financial institutions may respond to negative interest rates by being more careful to match their deposits and lending on a day-to-day basis.  Suddenly when you want a loan or to deposit funds the bank will start saying “you meet our criterion, but we have a waiting line for approving loans/deposits and it will occur when you come to the front of that line”.

This would reduce the volatility of money and in turn restrict economic activity.  This is a mechanism that may lead to negative interest rates reducing growth – if the negative interest rates also involve an increase in non-interest restrictions to lending.

But a negative cash rate pays people to lend!

Good point and very consistent with what we’ve done in class. As a result, this discussion requires further explanation.

When cash rates are negative it is true that a financial institution will now be willing to lend at a lower interest rate (given that they can “borrow” from settlement cash at a more attractive rate), so at face value there is no reason to think such negative rates will restrict lending.

But we also need to remember that the borrowing also credits a banks account.  If the person being lent to then deposits the funds in another banks account that other bank will be a bit unhappy about having to pay the negative interest rate on it – and if the person immediately spends it those funds will be deposited.

As a result, banks will want to restrict deposits.  In so far as a bank restricts credit being paid into their account, they can create an issue for loans – which in turn could restrict how quickly loans could take place.

When interest rates are positive you have same issue from lender, but with negative it is the deposit taker that pulls back.  With positive interest rates, lenders are increasingly unwilling to lend as rates go up (due to the uncertain cost of mismatch), with negative rates the deposit taker becomes unwilling to accept funds as rates go down – both break down intermediation, but with positive rates that is the goal – with negative it is not.

Furthermore, even if the loan came back to the same bank as a deposit if the zero lower bound on deposit rates is binding (which it seems to be – with deposits rates in countries with negative cash rates staying at zero) for financial institutions then charging lower interest rates on investment will simply reduce the net interest margin of banks.  With negative spillovers from uncoordinated lending in this sense, tacit collusion between banks might see them agree to cut lending to support margins – making negative rates at best useless and and worst a device that leads to uncompetitive behaviour.

Overall, thinking about how cash rates translate into negative interest rates – and the broader concerns in Eggertson etal 2018 – indicates that negative interest rates may not be as useful as our models in class suggest, where all that mattered was the investment function and the related impulse to investment this suggested.

However, this is an area economists are still trying to understand using data – so hopefully in the future we will have a better idea of what elements are relatively more important!

The main reason for discussing this is to show that, although our models in class are useful – they are not always the whole story. And given unique circumstances it is important to think about other margins that matter. Remember the Joan Robinson quote from the start of the semester – we are learning how to question things, not incontrovertible facts.