Fighting excessive deflation once interest rates have been reduced to zero

Fighting excessive deflation is in some ways more difficult than fighting hyperinflation.

During inflationary times, there is basically no limit to how much central banks can raise interest rates.

But in the battle against deflation, once interest rates have been reduced to zero, there is little that central banks can do to stimulate further growth.  

The two things that can be done once interest rates reach zero are:

• negative interest rates or 
• quantitative easing.

Negative interest rates

In times of negative interest rates depositors are essentially being charged to store their money in the bank.

Negative interest rates has been the case in the past, in countries including Switzerland and Denmark.

This encourages consumers and businesses to put their money in the economy at large by buying additional goods and services.

Strategies for Banks to Make a Profit in a Low Interest Rate Economy

By Steve Lander

Low interest rates don't have to eliminate a bank's profitability. 

A low interest rate economy can be challenging for the banking sector. After all, if banks earn profit by lending out money and they can't charge as much for the money they lend, it's harder to maintain the same level of profitability. However, low interest rate markets still offer opportunities for banks to do extremely well. These strategies are as open to small community and business banks as they are to the largest institutions. 

Fee Revenue 

Instead of earning money by borrowing and lending money, banks can turn to fees to boost profits. For example, banks can charge overdraft fees when customers try to draw money that they don't have from their accounts. One $35 overdraft fee per year generates as much revenue as lending out $1000 at 3.5 percent for the year. Banks can also charge ATM usage fees, account maintenance fees, statement copy fees and just about anything else they can imagine. 

Origination and Turnover 

Another option for banks is to continually recycle their money, such as in the mortgage market. Instead of making a traditional 30-year mortgage loan and tying up their income for a long period of time, banks can make and sell loans. When the bank makes the loan, it ties up a portion of its capital in the loan at a low interest rate. However, the bank can turn around and sell that loan to an investor and, hopefully, realize a profit on the sale. The bank then has the money back to lend again so that it can continue flipping the funds. 

Changing the Spread 

When the rate that a bank can charge plunges, it creates an opportunity for them to increase their profit by charging a little bit more relative to the market. For example, if mortgage rates should go from 8 percent to 4 percent, it's unlikely that a customer would complain or even notice if the bank dropped its rate to 4.25 percent instead. After all, the customer is still saving a great deal of money relative to previous rates. Doing this helps to cushion the blow of low rates and protect or even increase bank profits. 

Rates Don't Matter 

A low interest rate market cuts both ways. While banks can't charge as much for loans, they also don't have to pay as much to attract deposits. Historical data from the Federal Reserve comparing the prime rate to the rate on a three-month certificate of deposit shows that they trade in a relatively tight band. Between 1995 and 2012, the average difference between the two rates was 275 basis points, and the spread varied between 212 and 320 basis points. When you take out the highest and lowest spread years, the range narrows to 267 to 297 basis points -- which is just over a 10 percent difference during 16 years of the 18 year period. For comparison, during that same period, the prime rate fluctuated from 3.25 to 9.25 percent and CD rates fluctuated from 0.28 to 6.46 percent. In other words, while rates change, the bank's profit, which comes from the difference between the deposit and loan rates, remains roughly similar.

https://smallbusiness.chron.com/strategies-banks-make-profit-low-interest-rate-economy-68922.html

How Negative Yields Work | WSJ

What Would Negative Interest Rates Mean For Consumers And The Economy?

How bonds with negative yields work and why this growing phenomenon is so bad for the economy

PUBLISHED WED, AUG 7 2019


KEY POINTS

About a quarter of the global bond market, or about $15 trillion worth of bonds, offer negative interest rates.

U.S. bonds are still paying something, but could go negative if there’s a recession.

Negative interest rates encourage government borrowing.





Imagine if I came to you with a deal.  Give me $10 today and I’ll return $9 to you in a decade or so.
No way right?  This is happening all around the world and on increasing basis.

Maybe you didn’t go to Harvard Business School, but perhaps you recall an early lesson from your Junior Achievement class that tells you this is not how it’s supposed to work.

You are supposed to put your money in the bank and be rewarded with interest. This is supposed to be wiser than trading your precious allowance at the candy store for an awesome, yet fleeting sugar rush.

Nicholas Colas, co-founder of DataTrek, put it plainly enough: “Bonds are supposed to pay the owner of capital something to pry the money out of their hands.”

Nevertheless, some really smart investors around the world now have invested about $15 trillion in government bonds that offer negative interest rates, according to Deutsche Bank. That represents about a quarter of the global bond market.


This financial insanity is overtaking the world because bond prices are skyrocketing as stock prices are tanking. As more money flows into bonds, their yields go down — even below zero in some cases.

The good news is that U.S. Treasurys, while hovering near all-time lows, still pay at least something. The 10-year was yielding 1.62 percent on Wednesday. Still, that’s low enough to stymie financial educators as they try to convince children that they should put off instant gratification and save at least some of their allowances.

Some market observers are now warning that the U.S. could be paying negative bond rates, too, if there’s another recession. Currently, our central bank, the Federal Reserve, has set its benchmark rate at 2.25%. When the economy turns south, the Fed typically lowers rates by as much as 5 percentage points to reignite borrowing and spending.

But where else can it go after it hits zero?

Paying any government to take your money is as irresponsible as feeding children nothing but candy bars. It’s what you might call a “moral hazard,” but this term seems to have been eliminated from the economics texts following the bailouts of reckless financial institutions in the 2008 financial crisis.

Negative interest rates, and even super-low interest rates, are only going to encourage more government borrowing. This in turn allows politicians to make all kinds of grandstanding promises — until one day when the debt pile gets too big, interest rates return to historically normal levels, and taxes go up to pay for it all.

So why does this happen?

Institutional money have investing guidelines they have to follow while shepherding all their billions. Those guidelines often require them to buy bonds. The demand for these bonds is rising sharply — so they take the deal of the day.

In the end, it’s not a good sign for the economy.



https://www.cnbc.com/2019/08/07/how-bonds-with-negative-yields-work-and-why-this-growing-phenomenon-is-so-bad-for-the-economy.html?__source=facebook%7Cmain&fbclid=IwAR15vbqWZbZc1qxFjw4gZscoU7Z2u7kcRKe5m7qGSWwD0q80RSwEWJxqRBs

Q&A: what are negative interest rates?

European Central Bank has cut the interest rate banks receive when they deposit money with the ECB

The ECB has cut its headline interest rate to a new record low of 0.15%, and also imposed negative interest rates of -0.1% on eurozone banks – to encourage them to lend to small firms rather than to hoard cash.

How do negative interest rates work?

Instead of earning interest on money left with the ECB, banks are charged by the central bank to park their cash with it. The ECB cut its deposit rate to -0.1% on Thursday and the hope is that this will encourage the banks to stop hoarding money, and instead lend more to each other, to consumers, and to businesses, in turn boosting the broader economy.

Will it work?

No one knows. In theory it sounds attractive but it has never been attempted by the eurozone and could have unpredictable and unintended consequences. Those consequences include the possibility that banks will pass on to customers the costs they incur for depositing money with the ECB.

A broad risk is that a negative return on parking funds with the central bank might encourage banks to invest in riskier assets to secure a return, potentially driving new asset bubbles and more pain further down the line.

As part of this bid to find alternative investments, banks are likely to increase their purchases of government bonds. However, this has potentially serious consequences if banks are holding bonds to such an extent that government borrowing costs are artificially low. If a financial shock occurs, the banks and governments could find themselves so intertwined and interdependent that they drag each other - and the economy - down.

Has it happened before?

Sweden and Denmark have introduced negative deposit rates on a temporary basis in recent years. In Denmark, the aim was to cap an unwanted rise in its currency, which was pushed higher when foreign money flooded into the country as investors looked for safe havens outside the crisis-ridden eurozone. The move to negative deposit rates did not cause financial meltdown, with the Danish central bank issuing plenty of advance warning. Nor did it lead to a noticeable change in the interest rates charged by banks for bank loans. But then again negative deposit rates have never been tried by an economy on the scale of the eurozone, and the fear is that the Danish example will have little read-through for the 18-member bloc.

What would it mean for me?

Very little in terms of the detail of the policy and any impact on retail banking rates. However, if it provided the desired boost to the eurozone economy and put it on the path to a sustainable recovery, that would be good news for the UK economy too. On the flipside, if there were some nasty unintended consequences, including a shock to the eurozone banking system, Britain's economic recovery could potentially be undermined.

Negative Interest Rates

Less Than Zero

By Jana Randow and Simon Kennedy | Updated Mar 10, 2016 10:19 AM EST

Imagine a bank that pays negative interest. Depositors are actually charged to keep their money in an account. Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero and kept them there for more than a year. Now Japan is trying it, too. For some, it’s a bid to reinvigorate an economy with other options exhausted. Others want to push foreigners to move their money somewhere else. Either way, it’s an unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire. If negative interest rates work, however, they may mark the start of a new era for the world’s central banks.

The Situation

The Bank of Japan surprised markets by adopting negative interest rates in January, more than a year and a half after the European Central Bank became the first major institution of its kind to venture below zero. With other options to stimulate the economy limited, more policy makers are willing to test the technique. They acknowledge that sub-zero rates can crimp the ability of banks to make money or lead them to take additional risks in search of profit. The ECB cut rates again March 10, charging banks 0.4 percent to hold their cash overnight. At the same time, it offered a premium to banks that borrow in order to extend more loans. Sweden also has negative rates, Denmark is using them to protect its currency’s peg to the euro and last year Switzerland moved its deposit rate below zero for the first time since the 1970s. Janet Yellen, the U.S. Federal Reserve chair, said in November that a change in economic circumstances could put negative rates “on the table” in the U.S. Since central banks provide a benchmark for all borrowing costs, negative rates spread to a range of fixed-income securities. By February, more than $7 trillion of government bonds worldwide offered yields below zero. That means investors buying bonds and holding to maturity won’t get all their money back. While most banks have been reluctant to pass on negative rates for fear of losing customers, a few began to charge large depositors.

Source: Bloomberg

The Background

Negative interest rates are an act of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans to businesses or to weaker lenders. Rates below zero have never been used before in an economy as large as the euro area. While it’s still too early to tell if they will work, ECB President Mario Draghi said in January 2016 that there are “no limits” on what he will do to meet his mandate. Europe’s central bank chose to experiment with negative rates before turning to a bond-buying program like those used in the U.S. and Japan. Policy makers in both Europe and Japan are trying to prevent a slide back into deflation, or a spiral of falling prices that could derail the economic recovery. The euro zone is also grappling with a shortage of credit and unemployment is only slowly receding from its highest level since the currency bloc was formed in 1999.

Source: European Central Bank

The Argument

In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead, robbing lenders of a crucial source of funding. But there’s mounting concern that when banks absorb the cost of negative rates themselves, that squeezes the profit margin between their lending and deposit rates, and might make them even less willing to lend. The Bank for International Settlements warned in a March 2016 report of “great uncertainty” if rates stay negative for a prolonged period. And if more and more central banks use negative rates as a stimulus tool, there’s concern the policy might ultimately lead to a currency war of competitive devaluations.

The Reference Shelf

• A Bloomberg comic explains how negative interest rates aim to put money to work.
• The Bank for International Settlements published a March 2016 report on negative rates.
• An analysis of the impact of negative rates in 2015 from Sweden’s central bank.
• Blog posts from Francesco Papadia, a former director general for market operations at the ECB, on whether the central bank should have negative rates, and a discussion about where rates could go.
• A speech by Benoit Coeure, a member of the ECB Executive Board, on monetary policy and the challenges of the zero lower bound.
• A Bloomberg News article outlining the pros and cons of a deposit rate of zero or below and a QuickTake on the ECB’s debate over quantitative easing.
• An ECB research paper on non-standard monetary policy and a Bank of England study of negative rates.

http://www.bloombergview.com/quicktake/negative-interest-rates

Could Negative Interest Rates Arrive In America? The Collapse Of Cash

Could Negative Interest Rates Arrive In America?

They already have. Beginning on May 1st, JP Morgan Chase has announced they will charge certain customers a “balance sheet utilization fee” of 1% a year on deposits in excess of the money they need for operations. That amounts to a negative interest rate on deposits. Banks formerly competed for your money--now they want to charge you to park it with them.  

With interest on deposits at next to nothing, or now slightly negative, the only reason for consumers to keep money in the bank is convenience. The more money you lose money on your deposits in the form of a “utilization fee”, the more attractive your mattress becomes. But, as long as paper money and your mattress are available, the Fed will not be able to fully implement its negative rate policy in its quest to create inflation. After all, there would be a global run on the banking system if rates were to fall into negative territory by more than just a few percentage points.

So how can central banks and governments ensure rapid money supply growth and velocity if consumers have the option to hoard cash? Some of the “best minds” in Keynesian thought, like Kenneth Rogoff, have a solution to this. They are floating the idea that paper money should be made illegal and the evidence shows governments are listening. If you outlaw hard cash, and make all money digital, there is no limit to how much borrowers can get paid to borrow and how much savers get charged to save. This would make it unprofitable to hoard cash, and compel people to consume and borrow electronic currency as fast as possible. Money in the bank would become the “hot potato”: as soon as it hits your bank account the race would be on to move it to the next person’s account.  Whoever gets stuck with the money when the music ends pays a fee; that would be some increase in velocity!  And vastly negative real interest rates would force the amount of leverage in the economy to explode.

This idea sounds fairly Orwellian–allowing central banks to control every aspect of monetary exchange and giving the Federal Government an electronic gateway to every financial transaction. But when you think about it, the idea of a fiat currency and the Federal Reserve were radical ideas before they became common place. Indeed, this is exactly why the authors of our constitution tried to ensure gold and silver would have the final and only say in the supply and value of money.

Just as gold once stood in the way of governments' desire to expand the money supply, physical cash is now deemed as a fetter to the complete control of savings and wealth by the state. History is replete with examples of just how far governments will go to usurp control of people under the guise of the greater good. Sadly, the future will bring the collapse of cash through its illicit status, which will in turn assist in the collapse of the purchasing power of the middle class. Wise investors would take advantage of the opportunity to park their savings in real money (physical gold and silver) while they still have a chance.  

http://www.talkmarkets.com/content/us-markets/the-collapse-of-cash?post=64180


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We are in our seventh year of record-low interest rates and banks have been flooded with reserves. However, the developed world appears to be debt disabled. That is, already saturated in debt, therefore unwilling and unable to service new debt due to a lack of real income growth.

So the problem for central banks and governments is how to get the money supply booming in an environment where consumers want to deleverage and save. Zero percent interest rates (ZIRP) are inflationary and negative real interest rates foment asset bubbles and encourage new debt accumulation. For decades central banks have used their control of the price of money to coerce boom cycles that eventually turn to bust. But for the past six years, their foray into ZIRP land hasn’t provided the boom cycle they were expecting. Sure, they have created massive bubbles in bonds and equities--but the economy has yet to enjoy the promised growth that is supposed to trickle down from creating these bubbles.  They have set the markets up for a bust, yet the economy never enjoyed the boom. 

This has left Keynesians scratching their respective heads and scheming new ways to encourage even more borrowing and spending. The Keynesians who rule the economy now control the price of money but are having difficulty controlling its supply and producing rapid inflation rates.

Bank deposits that pay nothing and ultra-low borrowing costs haven’t proved effective in boosting money supply and velocity growth. The growth rate of M3 has fallen from 9% in 2012, to under 4% today. And monetary velocity has steadily declined since the Great Recession began. Therefore, unfortunately, the next baneful government scheme is to push interest rates much further into negative territory in real terms; and also in nominal terms as well! 

You would think this is absolutely absurd but it is already happening. The European Central Bank, has a deposit rate of minus 0.2 percent and the Swiss National Bank, has a deposit rate of minus 0.75 percent. On April 21st the cost for banks to borrow from each other in euros (the euro interbank offered rate, or Euribor) tipped negative for the first time. And as of April 17th, bonds comprising 31% of the value of the Bloomberg Eurozone Sovereign Bond Index, were trading with negative yields.

UK: 40pc chance of a rate cut? Really?

A 40pc chance of a rate cut? Really?

By Edmund Conway Economics Last updated: September 9th, 2009

2 Comments Comment on this article

About a month ago, in a throw-away comment at an economic conference, Charles Goodhart, a former member of the Bank of England’s Monetary Policy Committee unwittingly caused a stir in the money markets. As I wrote at the time, he raised the idea of the Bank imposing a negative interest rate, in other words charging a fee, on the cash Britain’s leading banks keep in store at the BoE itself.

The idea has snowballed, to the extent that in the run up to tomorrow’s MPC meeting, the odds on the Bank cutting its rate are, according to market participants, about 40pc. So might tomorrow mark the onset of negative interest rates for the first time in the UK? I am sceptical.

First, let’s examine the problem. The Bank is trying to get the economy going by pumping £175bn into it through quantitative easing. What this actually means is creating money (yes, printing it - electronically) and using this to buy bonds - almost exclusively government bonds (gilts) - off private investors. The upshot is that as that money goes into the system it finds its way pretty quickly to banks’ balance sheets (either because they sell the Bank the gilts or because pension funds pocket the proceeds and put them in their bank accounts).
Banks tend to keep a good deal of their cash in their own equivalent of a current account - reserves at the Bank of

England. So the upshot of quantitative easing has been to lift the amount sitting in reserves at the Bank to unprecedented highs - up from below £10bn to £142bn at the last count, in August. At the moment, the Bank pays banks a 0.5pc interest rate on this “current account” cash - the same as the BoE bank rate.
The problem is that much of this money is sitting dormant in the banks’ reserves rather than being used to lend to businesses, where it will actually help fertilise UK economic growth. This is the problem the Japanese faced in the 1990s and early 2000s when they first experimented with QE.

Anyway, Prof Goodhart’s suggestion was that the Bank should charge banks to keep this cash with them, rather than giving them 0.5pc interest. This is something the Riksbank in Sweden is experimenting with. The result would not necessarily be that reserves would fall throughout the system as a whole, but the cash would at least be sloshed around the system a little more (velocity is the technical term here) in the form of lending to businesses and companies.

It was an interesting suggestion - interesting enough for BoE Governor Mervyn King to say this at the Inflation Report press conference last month:

It is certainly true that it would be useful to think about ways to encourage banks individually to try to convert some of their reserves into say shorter term gilt holdings or purchases of other assets which would then reinforce the transmission mechanism of the direct assets purchases that we make. And in normal circumstances you might expect that to have some impact. And there is no doubt that the interest rate that we pay on reserves does affect the incentives which banks face to turn those reserves bank by bank individually into other assets. And it’s an idea we will certainly be looking at to see whether in fact the effectiveness of our asset purchases could be increased by reducing the rate at which we remunerate reserves.

Hence the fact that the market is all of a flutter about the prospects that the Bank would do so at this month’s meeting. However, there are some things people have overlooked. The first is that cutting the rate paid on reserves to banks from, say, 0.5pc to 0pc, would be an overall interest rate cut in all but name. It would push down the overnight rate in money markets to close to zero, which in turn would cut borrowing costs across the wider economy (though it wouldn’t affect tracker mortgages etc). So if you’re cutting the rate paid on reserves, why not cut the Bank rate? It is a prospect that is not beyond the realms of possibility tomorrow, though the Bank did make it pretty clear back in March that it viewed 0.5pc as “effective zero” for rates: below that level weird and not so wonderful things would happen in financial markets; certain businesses could malfunction. Think of it as the “millennium bug” effect for financial markets.

Should the Bank be unwilling effectively to cut Bank rate, it could still charge a fee to banks on a proportion of their reserves, allowing them to keep a certain amount (say, in comparison with the size of their balance sheet) but levying a penalty on any extra cash in their coffers. This is pretty close to what Goodhart was suggesting and is a feasible option tomorrow. But I wouldn’t put a 40pc chance on it.

My scepticism stems from a couple of key points. First, there are some early signs that QE is working even without such assistance. The amount of cash flowing around the wider economy - beyond reserves - is starting to pick up. Second, such a move would effectively amount to a tax on the banking sector as a whole. Third, it would also mean tearing up the complex set of rules and regulations that frame Britain’s monetary system once again.

Fourth, and perhaps most importantly, people seem to have forgotten that at the last MPC meeting something unusual happened: Mervyn King was outvoted. The Governor wanted the QE total to reach £200bn rather than the £175bn the MPC eventually opted for. In other occasions when he was outvoted, King usually attempts to get his way in a subsequent meeting. So might it not be more likely that the Bank will opt for a little more in the way of QE?

Perhaps, perhaps not. The fact is that market participants, having been surprised by the Bank’s decisions again and again in recent months, are suffering a slight degree of paranoia these days. Having been burnt more than once, they are putting greater odds on a surprise decision than they really ought to be. This is a tougher meeting to call than last month’s (to my mind at least, though the markets misjudged that one). And that’s for good reason: the economy is showing at least some signs of recovery - though this does not rule out a further relapse next year, something I’ve written about a number of times. This may well be one of those meetings when the MPC judges it best simply to do as little as possible. A boring MPC meeting? Never thought I’d see the day that one of those would be the exception rather than the norm.

http://www.telegraph.co.uk/?source=refresh