Negative Interest Rates

Secular Stagnation is a slump that is not a product of the business cycle but more-or-less a permanent condition. - Bloomberg Businessweek

As I have mentioned in previous blog posts banks are awash with reserve cash and are using that cash to make themselves enormous profits by receiving money in the form of interest from the Reserve Bank and by placing bets in the massive derivatives markets.  In order to stimulate an economy using an easy monetary policy it is imperative that the money that is "printed" makes its way into the hands of the entrepreneurs that are the backbone of the economy.  This is not happening for the simple reason that the money being "printed" is being given straight back to the Reserve Bank.  This may be resulting in Secular Stagnation which is an economy that is stuck in a long term state of stagnation for the simple reason that the money being used to stimulate is not reaching the economic drivers of small business and the consumer.

A simple solution to this problem would be to charge banks interest on these reserves.  This would result in a negative rate of interest and would instantly reduce the massive reserves that are held at the Reserve Bank to a minimum.  Now to understand negative rates you need to understand the theory.  Banks require a rate of return that is not only higher than their borrowing costs but also takes into account the erosion of their capital base through inflation.  While the spread they receive may be low, leverage provides the profit however this leverage is being provided by the derivatives market rather than by lending to businesses and households (for a more full description of this see my previous blog).  Charging them interest on their reserves would immediately reduce reserves to a minimum and result in massive amounts of investment capital coming onto the market.

In the past banks were not paid interest on their reserves and therefore it was enough to lower interest rates to close to zero to stimulate bank lending.  Also in the past inflation hovered around 2.5% so lowering interest rates to zero resulted in an implied negative rate of interest.  The problem is that today, with inflation running at a rate around 1% or possibly lower, lowering the interest rate to 25 basis points really does not do the job.  Taking Japan as an example it can be clearly seen that while they have printed inordinate amounts of money and have held interest rates at zero for decades, deflation eroded any stimulus and has not provided the economy the boost required.  Using this example you can clearly see that no amount of money thrown at an economy can solve this dilemma until rates are negative.

The United States can achieve a negative rate simply by charging banks interest on their reserves but the issue now is that with more than $2 trillion piled up in reserves the results are hard to quantify for the simple reason that there is no control of where that money would end up.  Had it dribbled into the economy in a controlled way that would be one thing but flicking the switch over to charging them interest would result in an avalanche of money flooding the system and it is anyone's guess as to the outcome.  Furthermore banks would fight this policy change for the simple reason that they are now making more money than ever and what banker would want to end the gravy train?  This is another reason why I firmly believe that interest rates will remain subdued and that real growth rates in the United States will remain anemic for the coming year which is why it is imperative that you find yield in places outside of the norm.