Are the world’s central banks running out of ammo?
Common wisdom says they are. The Fed has had overnight rates at zero and the “extraordinary policy” of quantitative easing (QE) in force for five years now, and the economy is slow-growing despite all the supposed stimulus. Surely Ben Bernanke and crew would have added more juice if they had any tricks left up their sleeve! Meanwhile, the ECB has cut its main overnight rate as about as low as it can go, and “experts” claim it won’t be enough to help the nascent recovery gain traction—and they warn the ECB might have to turn rates negative to get things moving. It’s all a bit overwrought, to say the least. One, all this supposedly stimulative monetary policy in the developed world has hurt, not helped. Two, the US and Europe have enough fundamental strength to keep growing anyway. Three, skipping wacky, “extraordinary” policy and going back to basics would provide both regions a nice tailwind.
The Fed and ECB have used different tactics, but their aim is the same: Tinkering with interest rates to boost demand for loans. With QE, the Fed reduced long-term rates by buying over $1.5 trillion (and counting) in long-term assets, believing lower borrowing costs would make homebuyers, car buyers, businesses and entrepreneurs more eager to get a loan—a monetary “bazooka,” some call it. Across the pond, the ECB tried to get money moving by making it cheaper for banks to borrow from each other.
Problem is, these same tricks have conspired with other factors to limit credit supply. In the US, it’s a combination of the flatter rate spread and tougher regulatory standards. By reducing long-term rates when short-term rates were pegged at zero, the Fed shrank the gap between the two—bad news for banks, whose core business is borrowing from depositors at short rates, lending at long rates and pocketing the spread. Small spread means small potential operating profit. Meanwhile, the very same Fed has ordered banks to build big capital buffers, and each new loan requires new offsetting liquid capital—with riskier loans carrying higher requirements. As a result, banks are lending only to the most creditworthy borrowers—super solvent individuals and investment-grade businesses. The potential reward from lending to most small businesses and entrepreneurs isn’t great enough to offset the higher balance sheet risk.
In the eurozone, it’s a confluence of variables. The low main overnight rate might make a bank more eager to borrow, but it doesn’t make a bank more eager to lend—and the rate in question is the rate at which banks lend to each other. There has to be an incentive for banks to keep money moving. Right now, there isn’t—instead, there are many incentives for banks to hoard capital (and cut consumer and commercial lending). Among them: Basel III capital standards, the ECB’s threats to impose even higher capital standards, the forthcoming stress tests and—most recently—the ECB’s admission it will force all banks who fail stress tests to implement “bail-in” procedures then and there (whether it can is up for debate presently). Even though the banks wouldn’t be technically insolvent, they’d be treated as such, potentially imposing losses on junior bondholders and large depositors. Needless to say, banks don’t want to risk this and have every incentive to focus on their balance sheets.
With this in mind, the suggestion a negative deposit rate could boost lending seems asinine. The logic behind negative rates assumes banks are holding big sums of excess reserves on deposit with the ECB or their national central banks because they pay 0.25%—a negative rate, some claim, would force banks to pull those reserves and lend them out. But how much of an incentive can a 0.25% return be? Especially when you consider UK bank reserves didn’t skyrocket when the BoE paid 5.5% on all cash parked there? The payment isn’t an incentive. It’s a tool central bankers use to keep balance in the financial system.
So what is driving eurozone banks to park cash? Other incentives! All those regulatory factors! Those drive banks to hoard capital regardless of the payment on reserves. If that rate turned negative, perhaps some banks would move funds elsewhere—the object, after all, is to raise capital buffers, not have a persistent negative deposit rate eat at them over time. But “elsewhere” wouldn’t be new loans. It would be highly stable, liquid assets like US Treasurys, UK gilts or German bunds (or something similar). The money would likely remain idly sitting on banks’ balance sheets, just in a different form.
Real monetary stimulus would boost the supply of new loans—it’s that simple. The more credit is available, the more lending you get. So how can central banks make credit flow? The ECB could start by chucking arbitrarily tough, ever-evolving capital standards for something more predictable and in line with international norms. They could drop threats to treat banks like they’re bankrupt simply because they fail an arbitrary stress test. They can make risk-weighting requirements clear and stable.
Beyond that, there is one simple, proven trick both the Fed and ECB have ignored for years—one that worked for decades. A simple, boring tool central bankers used before they tossed the old playbook—without even using it—and went straight to “extraordinary.” The Fed and ECB control two primary rates each. One is the rate at which banks lend to each other—the Fed Funds rate in the US and the refi rate in the eurozone. The other is the rate at which banks borrow from the central banks—the discount rate here, the marginal lending facility in the eurozone. Historically, when the Fed needed to boost liquidity, it moved the discount rate below the Fed funds rate so banks could borrow cheaply from the Fed, lend to each other at slightly higher rates and keep the spread—an incentive! The Fed never did this in 2008 or after—the discount and Fed funds rates are the same. In the eurozone, the marginal lending facility rate is half a point higher than the refi rate. That locks up credit. Adjusting the spread between these rates wouldn’t be a fix-all for either region, but it would be an incremental tailwind to money supply growth.
Not that either the US or eurozone needs central bank help—the US has grown over four years despite some of the worst monetary policy on record, and the eurozone exited its recession despite tight credit to consumers and businesses. They can keep moving forward even if their central banks don’t improve policy. But if the Fed and ECB would just get back to basics, the global economy (and markets) would benefit.
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