Why negative interest rates are contractionary, the base money confusion

FT Alphaville had an interesting email exchange with Peter Stella this past week, snippets of which we would like to share (with Stella’s permission).

Stella is currently the director of Stellar Consulting, an organisation that provides macroeconomic policy advice and research to central banks, governments, and private clients. He was formerly the head of the Central Banking and Monetary and Foreign Exchange Operations Divisions at the International Monetary Fund. He has co-authored a number of papers on the topics of money supply, collateral and risk-free assets.

He got in touch with FTAV because of what he feels is a gross misunderstanding in policy and journalistic circles regarding the nature of central bank reserves, and the myth that banks are not lending because they prefer not to.

As he noted to us:

From journalists, former colleagues, professors at Harvard, Yale and Columbia. I have been reading similar ideas/commentary for almost 5 years. That is, somehow bank reserves at the central bank ought to be “lent out”, i.e. should exit the “vault” of the BOE, Fed or ECB and begin circulating in the economy. The obverse of this is that an increase in excess reserves at the central bank reflects commercial banks “hoarding” liquidity rather than lending it “out”.

All this, he feels, is leading to ill-advised policy suggestions, such as negative rates, which are wrongly believed to encourage lending. The long and the short of a closed monetary system like ours is that base money quantity is always determined by the central bank and nobody else. If the central bank chooses to create excess base money, no matter how much lending goes on, excess base money will remain on the balance sheet at the central bank.

As Stella wrote:

Naturally, this stunningly incorrect conceptualization of the lending process and how it interacts with bank reserves leads people to think how to entice banks to “get this money out the door” including to thoughts of “negative” deposit rates as an incentive.

My frustration lies in my inability to explain to “sophisticated” people why in a modern monetary system–fiat money, floating exchange rate world–there is absolutely no correlation between bank reserves and lending. And, more fundamentally, that banks do not lend “reserves”.

Commercial bank reserves have risen because central banks have injected them into a closed system from which they cannot exit. Whether commercial banks let the reserves they have acquired through QE sit “idle” or lend them out in the interbank market 10,000 times in one day among themselves, the aggregate reserves at the central bank at the end of that day will be the same.

There is nowhere else they can go in a closed system. I cannot hold a deposit at the ECB, or at the Fed, or at the Bank of England. Not even the Fed’s primary dealers have accounts at the Fed, they operate through clearing banks who are depository institutions. So it simply not possible for the banking system as a whole to make its deposit balances at the central bank decline by trading with anyone other than the central bank itself.

Thus, just because deposits are rising at the ECB (and elsewhere), does not mean banks are not lending — something Bank of America Merrill Lynch has attempted to explain before too.

As Stella points out, the US banking system could increase lending a thousandfold this year without any change in their deposit holdings at the Fed.

The only exception to this is if lending constitutes a sharp rise in physical banknote withdrawals from the system. Or for that matter if commercial banks begin to store reserves in physical banknote form rather than on deposit at the central bank so as to avoid negative charges:

It is true that banks could reduce their excess deposits at the central bank by exchanging them for physical banknotes and then lend those banknotes out to retail customers. And yes, when I worked on Argentina in the late 1980s banks did settle among themselves by transferring massive amounts of US dollars in armored cars that choked the streets of the “city” in Buenos Aires and yes, when I worked on Liberia in the 1980s banks settled among themselves through transfers of US dollar cash or US balances abroad, but we are, I think/hope, a bit distant from that point in Europe–well, apart from Greece.

But the point stands. Reserves, also known as base money, can only be extinguished by the central bank as part of strategic balance sheet reduction policy. This in itself can only be achieved through outright asset sales, reverse repos, negative rates or to a lesser extent by auctioning term deposits.

It thus stands to reason that negative rates — by reducing the central bank’s balance sheet — are contractionary rather than accommodative when it comes to credit supply.

As we’ve noted before, bank reserves do not leave the doors of the central bank when credit expands, because one man’s loan is another man’s asset. Every time a bank lends, it actually creates brand new credit. This is done by creating a liability for the borrower on one side, and an asset for itself, which can then be sold on, on the other side. Every increase in credit thus comes with an equivalent increase in savings vehicles. Credit is created with one hand and absorbed by the other hand.

The money which the bank creates via lending — banknote withdrawal excluded — is either spent on assets and goods, and thus put back on deposit via the seller of those assets, or left on deposit outright by the borrower. If it is not redeposited at the same bank it is possible that the money is debited from the bank’s account at the central bank. However, it never leaves the system. So broad money supply rises, but the amount of base money remains the same — irrespective of how much lending takes place.

If the bank chooses to sell the loan to a third party, it does so for money which is transferred from somewhere elsewhere in the system. Once the asset is sold, the bank is left neutral. If it chooses to keep the asset on its books, it grows its balance sheet to accommodate it, becoming exposed to the asset in the process.

The bank makes a profit for as long as it can borrow from other banks, ideally unsecured, or the central bank more cheaply than it lends money out. And, for as long as the asset performs.

There is no limit to how much banks can expand credit in this way. The same base money is passed around like a hot potato, creating offsetting assets and liabilities every time it hops. Another way to look at it is that base money is what’s left over after all banking liabilities (deposits) and assets (loans) are offset against each other.

In systems that carry minimum reserve requirements, base money must at the very minimum cover these required ratios. In these cases, when credit rises base money must also rise or else banks could fail to meet such ratios. However, the central bank almost always provides enough base money to ensure that these ratios are met.

In fact, this is how the central bank enforces policy. If it wants to influence interbank rates higher, it ensures there is slightly less base money than needed, encouraging banks to fight over available funding by outbidding each other on rates. If it wants to influence interbank rates lower, it ensures there is more base money than needed, encouraging banks with surplus cash compete to lend by dropping rates.

This is why excess reserves are needed to pin rates near zero. (It’s also why too many excess reserves lead to voluntary capital destruction via self-imposed negative rates, a phenomenon we are seeing in Germany).

In systems that don’t carry minimum reserve requirements, base money becomes a function of banks’ own liquidity needs, and adjusts in line with risk and non-performance of loans.

Negative rates phenomenon

If imposed, negative rates would be enforced via the base money market. This could see banks charged for holding excess reserves at the central bank. Which ever way you look at it, the move would ultimately be contractionary rather than expansionary because it would lead to base money destruction, or wider credit destruction as banks hand over credit to cover charges. The excess reserves the central bank created with one hand would be wiped out with the other — creating an overall tightening effect unless new base money was continuously created to compensate for the contraction.

Alternatively, interest on central bank deposit facilities or reserves could be dropped altogether. This would encourage reserves to seek out principal protected assets until market rates were influenced into negative territory due to the crowding out effect, a la Switzerland.

Of course, rather than hold money in negative yielding assets or in reserves that are subject to charges, banks would eventually become encouraged to hold reserves in physical banknote form instead. This would be especially the case if the vaulting fee was lower than the negative charge.

Which brings us back to Stella:

All this brings me back to the issue of imposing a negative interest rate on commercial bank balances at the central bank. I cannot understand how anyone could think this would spur lending. First, as we have already said, bank reserves do not “leave” the doors of the central bank when credit expands. Second, banks would respond like any business whose inventory is subject to a new tax. They would reduce their inventory, that is, shrink their operations, not expand them.

Banks would do this by repaying outstanding loans they have from the central bank and by stockpiling banknotes and storing them in vaults presuming the storage and insurance cost is less than the charge. This might lead to an increase in vault building and bank robbing, but credit? In other words, if HMT imposed a 5 percent a year tax on inventories of raw sugar who in their right mind would think this would spur candy production? Cadbury would hold more inventory in candy, less in sugar, and have their suppliers abroad pile it up.

All less efficient than what they were doing. Isn’t this basic economics 101? And this is an example of a business where the inventory (sugar) is needed for production. In banking today deposits at the central bank are totally unnecessary for lending.

So in short, excess reserves do not mean banks are not lending, and enforcing negative rates may do more harm than good because it is ultimately contractionary rather than expansionary, unless accompanied by ongoing asset purchases by the central bank.

(And that applies even if you kill the banknote arbitrage option by banning currency.)

Related links:

The strange case of ‘funding-for-lending’ confusion – FT Alphaville

On the transfer of risk and the mystery of low yields – FT Alphaville

The ‘high-powered money’ problem – FT Alphaville

Draghi May Enter Twilight Zone Where Fed Fears to Tread – Bloomberg