Bank of Japan warms up the potato

Will the Bank of Japan's negative rates work?

Many people say no, among them Louis-Phillippe Rochon:

Sadly, they won't. They [negative rates] are based on a faulty understanding of our banking system. The reason banks do not lend is not because they are constrained by liquidity, but because they are unwilling to lend in such uncertain times.

Banks lend in the hope of getting reimbursed with interest. But banks are too pessimistic about the ability of the private sector to honour their debt, and so prefer not to lend. Having extra cash courtesy of the central bank imposing negative rates won't change the dark economic narrative. [link]

I disagree. Even if the lending channel is closed, a negative rate policy still sets off a hot potato effect that gets the Bank of Japan a bit closer to hitting its inflation targets and stimulating nominal GDP than without that same policy.

For the sake of argument I'll grant Rochon the point that negative rates might not encourage banks to lend. And as you'll read in the comments here, that would certainly have implications on the effectiveness of monetary policy. But even if we close the door on loans, the interest rate cut will simply find a different route into prices and the real economy.

The moment the BoJ reduces the rate on deposits it creates a hot potato; an asset with a below-market return that its owner is desperate to be rid of. Bank reserve managers will simultaneously try to sell off their BoJ deposits in order to get a better return in short term corporate and government debt. In aggregate, however, banks cannot get rid of reserves, which pushes the prices of these competing short-term assets up and their expected returns back in line with the return on balances held at the central bank, a process that continues until reserve managers are indifferent on the margin between owning BoJ deposits and short term corporate/government debt.

The hot potato doesn't stop here but continues to cascade through financial markets. At the margin, corporate and government debt will now be overvalued relative to other financial assets (like stocks), encouraging fund managers and other investors to bid up the prices of all remaining assets in the financial market until returns are once again in balance.

Up till now the the hot potato that I've been describing has been trapped in Japanese financial markets thanks to Rochon's blocked lending channel. Acting as a bridge into the real economy are the portfolios held by consumers. Japanese consumers own not only portfolios of financial assets but portfolios of consumption goods that yield an ongoing flow of consumption services. Think cars, shavers, tables, and vacations (the latter of which yield a recurring flow of memories). Likewise, financial assets yield an ongoing flow of consumption services since interest payments and the final return of principle can be measured in terms of consumption. When prices in financial markets rise and returns fall, a portfolio of financial assets now yields a smaller discounted quantity of future consumption services than a competing portfolio of consumption goods. In response, consumers will re-balance out of financial assets into undervalued consumption goods, causing consumer prices to rise. Or, if there is some stickiness in prices, the quantity sold experiences a boom.

And that's how the hot potato ignited by the Bank of Japan's negative rates gets passed into consumer prices and the real economy when the lending channel is closed.

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Another interesting critique of the effectiveness of negative rates has to do with the fact that in those nations that have already experimented with negative rates, the penalty has not been passed through to retail deposits. This could be a problem because if Japanese retail depositors are not going to be fined by banks, that nullifies the hot potato effect I described above. After all, consumers won't bother trying to re-balance out of the financial economy into the real economy if they can just hoard superior-yielding 0% deposits.

This failure to pass-through negative central bank rates will probably not be more than a short-term phenomenon. As the BoJ deposit rate get ever more negative, those banks that choose to prop up the rate sthey offer on retail deposits allow themselves to be the victims of arbitrage, consumers taking the positive end of the deal as they migrate into superior-yielding deposits. Borrowing at 0% to invest at -0.1% isn't a particularly profitable place for a bank to put itself in. The only way for a bank to rectify the situation is by the passing-through of negative rates to retail clients or the setting of limits on retail account sizes. The hot potato effect gets new life as investors flee bank deposits by purchasing underpriced consumer goods.

As Gavyn Davies points out, the Bank of Japan has set a tiered negative rate whereby the full effect of negative interest rates is not felt by banks; only a portion of deposits held at the BoJ will be docked the full 0.1% while the rest get off Scot-free. This BoJ (i.e. taxpayer) subsidy to banks helps offset any financial losses that banks incur by choosing to avoid passing through negative rates to retail customers, thus encouraging bank managers to keep retail deposit rates steady at 0%. .

But as the BoJ continues to cut rates, the size of the BoJ subsidy is unlikely to increase as fast as the size of the penalty imposed on banks as measured by the gap between the cost of maintaining 0% retail deposit rates and the revenues earned on negative-yielding central bank deposits & other short term money market assets. To plug these growing losses, and absent a compensating subsidy, banks will have no choice but to pass-through negative rates to retail clients or put a limit on retail account sizes. This in turn will give free rein to the hot potato effect.

Negative interest rates are like water, they'll always find a crack.