In the aftermath of the global financial crisis of 2008 we have seen central banks across the world resort to unprecedented monetary policy measures in order to steer the economy back on track. Sweden’s Riksbank was the first central bank to explore negative rates, a concept that markets have become accustomed to now, but which seemed unconceivable not too long ago. Now the question that’s on everyone’s mind is what happens when the next recession hits and there isn’t much room to stimulate growth via monetary policy measures.
With the appointment of Christine Lagarde as head of the ECB in November, the central bank has been acknowledging that cutting rates and using QE have their limitations and additional measures need to be take in order to avoid a “Japanification” of Europe. Her first course of action was to call out eurozone governments that run low deficits to bolster their spending. Even though this makes sense from an economic perspective, coordinating the major European governments to jointly implement fiscal policies is not the easiest of tasks. As the need for alternative measures is becoming somewhat critical, the idea of using dual interest rates for borrowers and lenders has been gaining more ground recently.
Historically, when a central bank has reduced interest rates, we expected spending to increase through lower borrowing costs and lower mortgages for households, increased asset prices, and increased investment spending by corporations due to lower cost of borrowing. However, when interest rates are very low or negative for long, the interest income that savers receive collapses (weighing on spending), bank profitability is damaged, while investors are pushed into riskier assets in their search for yield.
Central banks have long had more than one interest rate, typically an interest rate is paid on funds held at the central bank, while another, more punitive rate is charged on lending electronic cash reserves. However, there is usually one effective policy rate (in the Eurozone it is currently the ‘deposit rate’, and in the US, it is the ‘Fed funds target rate’. In very simple terms, by having a single (negative) interest rate policy that targets money market rates (rates at which banks lend to each other), the net effect of increasing the disposable income for borrowers will be offset by lowering the disposable income of deposit holders. Therefore, in order to create stimulus, the marginal propensity of borrowers to consume should be higher than savers. The ECB has recognized the need of a tiered structure of interest rates, and under the latest amendment to TLTRO III in September 2019, it exempts a portion of the banks’ overnight deposits from charges
Under a conventional monetary policy, the discount rate (rate at which institutions borrow money from the central bank) is set above the policy rate, as a disincentive to banks who are in need of short-term liquidity. In contrast if a dual rate model is implemented, the ECB can determine the quantity of credit they will make available to the banking system by artificially setting a rate that is sufficiently attractive for them to issue new loans.
Current Effect of the TLTRO III Programme
Source: Marcello Minenna Academic Fellow at Bocconi University
In case further stimulus is needed, the ECB can reduce the lending rate without negatively impacting deposits. In this scenario banks will not be penalized as heavily for holding deposits with the central bank, while the lower borrowing costs will be transferred in the real economy. The net interest income of the private sector rises, and there is a large increase in lending. This model implies a transfer of financial resources from the ECB to the economic system, by reducing it profits accounted on its balance sheet.
In recent decades, we have seen this dual rate system in effect in the Chinese banking system where price controls over deposit rates and quantity controls over loan volumes were implemented, although the government involvement and bank dominance differentiate it from its Western counterparts. However, asserting different forms of control over deposit and lending rates has allowed the People Bank of China to adequately manage monetary policy without the need to resort to other unconventional instruments.
China Dual-Track Interest Rates
Source: M&G Investments
If the ECB decides to abandon the current philosophy of using QE for how ever long it’s needed and commits to a dual rate approach, we can potentially see the Eurozone become one of the early major economies that could manage to escape the low interest rate and low inflation environment, potentially offering the single currency a major boost.