Low interest rates are supposed to accelerate economic growth. But if central banks cut rates too much, they could actually slow the economy. So says a counterintuitive theory that’s making the rounds in academic and banking circles.
“Fed actions may be having little effect, or even effects opposite to those the Fed intends,” Charles Calomiris, an economist at Columbia Business School, wrote in an article in the winter issue of the libertarian Cato Journal called “The Microeconomic Perils of Monetary Policy Experiments.”
The concept that central banks might inadvertently make matters worse starts from an uncontroversial principle: Banks make money on the difference—the margin—between how much they must pay to attract deposits and how much they can earn by lending them out. Problems arise when central banks lower interest rates toward zero or even below, because the banks’ profit margins get compressed. The rate that banks are able to earn on their loans is pushed down by the central bank’s action. But they can’t lower how much they pay for deposits by an equal amount. That would require them to pay less than zero for deposits, which depositors won’t stand for. People would rather keep their cash under the mattress than pay to keep it in a bank.
When interest rates are ultralow, banks’ profit margins on loans are so small that they have no real incentive to take on the risks of lending. Instead they put their money into safe assets such as Treasury bills, which yield almost as much as loans would. That suppresses the volume of loans, especially the ones that banks retain on their books such as commercial and industrial loans.
“We need to get back to a normal-functioning federal funds market. Then we will know better what the Fed should be doing,” Calomiris says. The Federal Reserve, he says, should raise the short-term rate that it controls by at least 1 percentage point right away. Doing so wouldn’t upset the U.S. economy, he says, and could even help it.
Banking organizations, without signing on to everything Calomiris says, share his concern about low interest rates. James Chessen, the chief economist of the American Bankers’ Association, said in a June 5 interview, “Interest rates have been too low for too long. It has created a problem for banks.” The Independent Community Bankers of America, which represents smaller U.S. banks, believes that “higher interest rates would be a net plus for the community banking sector that would help them extend more credit,” according to spokesman Paul Merski.
Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig, on a June 5 visit to Bloomberg headquarters in New York, said raising interest rates now—as the Federal Reserve is gradually doing—will have mixed effects on the banks that his organization oversees and insures. “It’ll probably be painful for some and pleasant for others,” Hoenig said. “It’s a big machine with a lot of moving parts.”
Some other economists who specialize in monetary policy conclude that the issue Calomiris is raising is more applicable in Europe and Japan than in the U.S., where interest rates have already begun to creep up. After keeping the range for the federal funds rate at an unprecedented floor of zero to 0.25 percent for seven years, the Fed began hiking it gradually at the end of 2015. The range is now 0.75 percent to 1 percent. Financial markets are betting on an additional quarter-point hike at the June 13-14 meeting of the Federal Open Market Committee.
Markus Brunnermeier, a Princeton University economist, co-wrote a paper with Princeton colleague Yann Koby last year that found, as Calomiris has, that below a certain threshold lowering the interest rate “becomes contractionary for lending.” He calls that tipping point the “reversal rate.”
What’s hard to say is exactly where the reversal kicks in. “It’s not clear at the moment that U.S. banks are constrained,” Brunnermeier says, pointing to the healthy profits and lending volumes of U.S. banks in recent years. While the U.S. may be out of the danger zone, he says, “in Europe it’s very different. The banks there are still in the reversal range.”
Philipp Schnabl, an economist at New York University, agrees with Brunnermeier that Europe and Japan are the places where ultra-low interest rates may be problematic. “To emphasize, this is an unusual period we’re coming out of,” he says. “There’s a lot of uncertainty in anything we say about monetary policy.”
Officials at the European Central Bank and the Bank of Japan are sensitive to the side effects of extremely low or even subzero interest rates. In a May 24 speech in Madrid, ECB President Mario Draghi acknowledged that low policy rates “may compress banks’ net interest margins and thus exert pressure on their profitability.” But he said that ECB researchers found that taking into account offsetting beneficial effects, “the overall impact of our measures on bank profitability was positive.”
To promote loan growth, the ECB makes four-year loans at annual rates as low as -0.4 percent to banks that prove they are expanding their lending to the real economy. The Bank of Japan is propping up its banks’ profits in a different way, by trying to make sure that the 10-year interest rate is higher than the short-term rate. That helps banks because they generally borrow short-term and lend long-term. In both Europe and Japan, the concept is that banks need to be financially healthy to provide the credit that the economy needs to grow.
Calomiris continues to argue that this isn’t just an issue for other countries, although he wrote in an email, “I agree that we are getting out of the trap if the Fed continues to raise rates this year.” He said that Fed officials are confused about how low rates affect economic growth but don’t want to reveal their uncertainty for fear of undermining their “mystique.”
Says Calomiris: “It’s one of the most interesting times in the past 100 years of the Federal Reserve’s history.”