Two weeks ago, at least two persons forwarded me the speech by Ben Broadbent, the Deputy Governor of the Bank of England and a member of the Monetary Policy Committee of the Bank of England. The speech was an attempt to strenuously deny any fiscal dominance of monetary policy and an attempt to reinforce the credibility of the monetary policy regime and its inflation targeting framework. In other words, there is no agenda to generate inflation.
Paint me cynical. But, if the central bank were to pursue an agenda of generating stealth inflation, it would have to deny it first. Otherwise, it is not stealthy anymore. It will be factored into the decision-making of all ‘economic agents’ and the purpose will be defeated. So, I did not find anything it that impressed me.
Then two days ago, this news-story appeared in Bloomberg. The Bank of England is going to explore how to implement negative interest rates. This was disclosed in the Minutes of the Meeting of the MPC held in September. The relevant paragraph is this (paragraph no. 52):
The Committee had discussed its policy toolkit, and the effectiveness of negative policy rates in particular, in the August Monetary Policy Report, in light of the decline in global equilibrium interest rates over a number of years. Subsequently, the MPC had been briefed on the Bank of England’s plans to explore how a negative Bank Rate could be implemented effectively, should the outlook for inflation and output warrant it at some point during this period of low equilibrium rates. The Bank of England and the Prudential Regulation Authority will begin structured engagement on the operational considerations in 2020 Q4. [Link]
Students and scholars can focus on the ‘decline in global equilibrium interest rates’. Now, any student of economics would know that a decline in the equilibrium interest rates suggest a structural or permanent decline in potential economic growth. That can lead to a decline in the equilibrium interest rate.
If so, how does it explain unaffordable real estate prices and how does it explain the current stock market valuations? Third, how is it possible to improve the structural or permanent decline in potential growth through reductions in policy interest rates or through asset purchases since it is well-known that monetary policy tools are better suited to address short-fun fluctuations in aggregate demand? Fourth, in the attempt to do so, what other distortions are being created and what price is being paid? Fifth, are those costs worth it? Sixth, where is such a cost-benefit analysis?
In the monetary policy report published in August, the Bank of England had a box item on negative interest rates, running into nearly four pages. It focused on the limited pass-through of negative interest rates because banks may not lower interest rates on bank deposits by households. Therefore, they would be worried about their net interest income and may not lower their lending rate. Hence, the transmission of negative rates is impeded.
Apparently, a paper by the European Central Bank, first published in June 2019 and updated in June 2020 found that in countries with negative interest rates, the policy worked as long as banks had sound balance sheets and were adequately capitalised. Such banks passed on their negative interest rates to depositors. Companies which could not do away with corporate deposits lengthened their deposits and reduced their bank deposit holdings to invest in tangible and intangible assets. You can find the paper here or here.
Even if I take it at face value, I wonder if it was possible to control for other factors here. Did the firms borrow because they sensed investment opportunities or because of low rates? Further, the paper probably makes no distinction between greenfield and brownfield investments. If well-capitalised banks passed on negative rates (not impeding the transmission effect of negative rates), then the question to ask is whether well-capitalised banks would have lent in any case without having to force them to increase the quantum of loans by lowering the return they made on each loan. In the process, their loan profiles are bound to suffer and, over time, they can become less well capitalised. Further, not much time has lapsed to ascertain the true and the full extent of the costs of such policies. Let us consider some of these costs.
In America, the funded status of the 100 largest corporate defined benefit pension plans increased by $93 billion during August as measured by the Milliman 100 Pension Funding Index (PFI) over July but, year-to-date, it was down 4.7%. [Link].
For S&P 1500 companies, the funded pension status was around 83% in August 2020 compared to over 100% in December 2007. [Link]. That is the contribution of UMP, QE and ZIRP.
This is the latest I could find on public pensions and that too, only for America:
The total funding gap for the 143 largest US public pensions plans is on track to reach $1.62tn this year, significantly higher than the $1.16tn recorded in 2009 in the aftermath of the global financial crisis, according to Equable Institute, a New York-based non-profit think-tank. The weak financial condition of the US public pension systems poses severe risks for the living standards of millions of employees and retired workers. Equable estimates that returns of US public pension plans averaged -0.4 per cent over the 12 months ended June 30, well below the 7.2 per cent targeted by these schemes [Link]
If large corporations who had multiple banking relationships and who could withdraw the bank deposit to invest had access to capital markets, then why should the central bank follow this route at all? According to the authors, smaller firms are afraid to withdraw their cash deposits for fear of hurting the bank relationship. If so, then the cash deposit-channel might work in the opposite direction. They will not withdraw their cash to invest nor will they earn interest on deposits. Therefore, at the margin, their risk-taking appetite might be impaired. So, such policies might end up favouring market concentration and the dominance of big players over SME firms in Europe that have been the backbone of their economies. The ECB working paper does not seem to have taken these into consideration.
Further, the paper confirms that banks, since they did not want to pass on negative rates to household deposits, increased their fees because fees are “significantly more opaque”.
Funnily, the Bank of England had published a working paper (Staff Working Paper No. 883: ‘Does quantitative easing boost bank lending to the real economy or cause other bank asset reallocation? The case of the UK’ by Simone Giansante, Mahmoud Fatouh and Steven Ongena, August 2020) that shows that banks that received reserve injection from the central bank as part of the asset purchase programme by the central bank directed their reserves to relatively higher-yielding sovereign assets in Europe with low risk weighting rather than using the funds to undertake real lending. So, the authors conclude that the central bank might be better off considering targeted lending programmes. Back to credit allocation!
Negative interest rate is being explored to ensure that real rates are negative and become more negative. But, if inflation is structurally low and cannot be pushed up through policy measures (my view is that they cannot push the inflation rate higher), then policymakers will keep pushing nominal rates deeper into negative territory and/or pursue other disguised and open forms of monetary debasement – nominal GDP targeting, average inflation rate targeting and purchases of all assets.
None of them would address the real economy goals of output, employment and inflation that the central banks are pursuing. Expect more distortions in the economy, asset markets and more frustration for the masses.