Wednesday, January 22, 2020

"European Central Bank has one item left in its toolkit: dual rates"

From Bond Vigilantes, January 9:

A version of this article originally appeared in the Financial Times last week.
There is a widespread assumption that the European Central Bank — like other major central banks — has reached the limits of monetary policy, and that the best we can hope for with Christine Lagarde’s reign is political astuteness in cajoling reluctant politicians to embrace a fiscal stimulus. 
This is not the case.
As Ms Lagarde prepares to launch a strategic review of the ECB’s policies and objectives, she has a final item left in the toolkit: dual interest rates. 

In practice, this entails the central bank targeting different interest rates for loans and deposits. Such loans can also be restricted to specific sectors, such as renewable energy. The policy would be more effective than quantitative easing, forward guidance or negative interest rates. It would provide a powerful monetary stimulus and could be used to turbo-charge Europe’s Green Deal.

The effects of dual interest rates are easiest to understand in contrast to standard policy. Typically, when a central bank reduces interest rates we expect this to boost spending in the economy through three basic effects:
  1. Interest rates fall for households with mortgages; 
  2. asset prices rise, making people feel wealthier; and 
  3. the cost of borrowing for companies falls, which should boost investment spending.
But serious problems emerge when interest rates are very low or negative. The interest income which savers receive collapses — weighing on spending — and bank profitability is damaged, causing many unintended consequences.

The application of dual interest rates
What would happen if the central bank raised the interest rate on deposits, and cut the interest rate on loans? Both savers and borrowers benefit. History tells us that such an approach will always raise demand.

The strongest recent evidence is from the Chinese banking system in the 1980s and early 1990s (see the differential movements in figure 2, prior to more parallel shifts in recent years)....