A few thoughts for JPK on negative rates and AD
Following my post on negative rates and banking instability, JP Koning commented and left a very interesting question:
Are you of the opinion that a rate cut into negative territory would reduce aggregate demand?
First, I’d like to apologise to JP for the very late reply. I had a crazy past week (for those who don’t know, I compete in powerlifting)…
While drafting an answer, I came to the conclusion that I should actually write a very short post as this might be of interest to a number of my readers. Here are some of my thoughts:
I think it’s tricky to answer. It will vary a lot depending on local factors and local culture.
But I believe that, if ever negative rates provide a boost to demand, it will be minimal and not worth the risk of extra financial instability it creates.
But quantitatively it’s really hard to say.
Some of the factors involved are (I’m surely missing a few other ones):
– Are banks going to charge retail customers or not?
– If they do, what is the local propensity to save more/spend more/withdraw cash/change nothing in response, and in which amplitude?
– Also, how will this affect the turnover on banks’ deposit base, and hence their funding stability, as deposits have traditionally been among the most stable funding sources. In line with the theory of my previous post, empirical evidences show that banks with less stable funding structures tend to contract their lending more (or at least grow their loan book more slowly) in periods of stress (see this very interesting paper by Ivashina and Scharfstein for instance). And less lending implies less demand.
– If not, how are banks going to deal with the decline in profitability while having to implement seriously disrupting banking reforms and generate extra capital to comply with regulatory requirements, while still retaining their shareholder base? Banks without shareholders just disappear. And an economy without banks usually doesn’t perform very well.
– Also, in order to prevent their RoE from evaporating, what is going to be the propensity of profitability-constrained banks to start hunting for extra yield by lowering underwriting standards, potentially endangering medium to long-term financial stability? And I fear that, in such case, banks would once again get blamed for the resulting crisis, leading to even more government intervention in the financial system. This can’t be good.
So there cannot be a definitive answer to JP’s question, with local culture and banking characteristics being determinant factors.
“– If they do, what is the local propensity to save more/spend more/withdraw cash/change nothing in response, and in which amplitude?”
Abstracting from the cash withdrawal option, won’t the same propensities that exist when central bank rates are cut from 4% to 3.5% also dominate when rates are cut from 0% to -0.5%? Why would people’s propensities to spend be stimulated differently by the same 0.5% rate cut?
My answer will be as precise as the previous one: I don’t know for sure.
But I suspect the function not to be linear, with ‘pain tolerance’ varying by country.
Interestingly, although not entirely comparable, banks in a number of countries charge(d) customers simply to maintain their current accounts open (France for instance used to charge between EUR5-15 monthly). This is effectively a sort of negative rate, albeit a fixed one that does usually not depend on the amount held in the account.
People were not withdrawing their money and closing their accounts, although I suspect that raising that fee too high would trigger an exodus towards competitors.
When rates are in positive territory I guess the mindset is different. Clients, from a nominal rather than real point of view, ‘earn less’ rather than ‘are charged more’. My guess is that tolerance to ‘earning less’ is higher than tolerance to being ‘charged more’.
But only comprehensive surveys asking people what they would do in all those cases would provide empirical data to build that tolerance function.