Negative Interest Rates Represent Monetary Tightening, Not Easing

Five months ago, when word was spreading that the Fed might cut the interest rate on excess reserves (IOER), I argued that making IOER negative equates to raising taxes. Part of the misguided notion that such a policy will be stimulative is due to the incorrect belief that banks are choosing to hold excess reserves on the central bank balance sheet instead of lending them out. Presenting work from the NY Fed itself, I tried to debunk that myth by explaining why cash “parked” at the Fed will remain there. Discussion of this policy has been revisited in Europe over the past couple months and its enactment remains a major risk to the global economy.

For those readers unconvinced by previous discussion or simply interested in the topic, Frances Coppola recently provided an in-depth look at the strange world of negative interest rates. Trying not to dissuade readers from viewing the entire post, here is a small sample (emphasis mine):

It's worth remembering, too, that reserves are created by the central bank, not by commercial banks, and that commercial banks have no power to reduce the total amount of reserves in the system. That can only be done by the central bank. So if commercial banks were discouraged by negative interest rates from holding excess reserves, but there were still excess reserves in the system, banks would look for ways of passing on those excess reserves to other banks. Excess reserves would become something of a hot potato, with no bank wanting to be caught with excess reserves at the end of the day. I suppose that might improve the velocity of money, but I could see it leading to all manner of stupid investments.

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But consider what would happen if an economy experiencing deflationary pressure introduced negative interest rates. The squeeze on the margins of already-damaged banks would inevitably lead to higher rates to borrowers and reduced lending volumes. This is monetary tightening, not easing, and the effect would be contractionary. It would make the recession worse.

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Like negative rates on reserves, negative policy rates could actually have a toxic effect on the real economy. Across Europe, including the UK, many loan rates - especially mortgages and business loans - are tied to the policy rate. So if the policy rate were cut to below zero, lenders would find their margins squeezed on existing lending: they could even find themselves receiving negative returns on these loans. Realistically they cannot cut their deposit rates to savers to below zero (savers would stuff mattresses instead), so their only option is to RAISE lending rates to new borrowers, widening credit spreads. Exactly the same effect as negative interest rates on reserves, in fact - and the same effect as QE.

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So cutting policy rates to below zero would be as counter-productive as cutting interest rates on reserves. And it would be unpopular. I can't imagine any electorate, wounded as they are by the behaviour of banks, tamely accepting bank funding being subsidised while interest rates to new borrowers soared and the economy crashed.