Dual interest rates

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Dual interest rates refers to a policy implemented by central banks which aims to influence lending rates independently of deposit rates as a means of stimulating economic activity. [1] Policies similar to this have long been a feature of Chinese monetary policy. [2] More recently dual interest rates have been introduced by the European Central Bank (ECB), under its TLTRO II scheme as an unconventional monetary policy. More aggressive use of these policies has been suggested as an effective alternative to negative interest rates, quantitative easing (QE) and forward guidance. [3] [4]

Contents

Historical context

Central banks have always operated with a number of different interest rates. Historically, the Federal reserve has relied on two interest rates, the discount rate, and the federal funds rate. The federal funds rate is the primary policy rate, which is aimed at determining money market rates, at which banks lend to each other. In conventional central banking, the discount rate is set above the policy rate, as a disincentive to banks who are in need of short-term liquidity. Under a policy of dual interest rates, however, central banks determine the quantity of credit they will make available to the banking system at an interest rate which is sufficiently attractive to encourage them to make new loans.

Under the ECB’s TLTRO III scheme, banks could obtain access to funds from the ECB at a rate as low as -1%, that is, -50 basis points below the standard deposit rate. [5] Access to these favourable terms is contingent on banks making new loans (except for mortgage lending). Research by the ECB has found that the introduction of dual rates "had a strong positive effect on bank credit provision during the COVID-19 crisis, helping to sustain economic activity [and was not] accompanied by excessive risk-taking". [6]

Supporters

Recognition of the monetary power of dual interest rates is relatively recent. Oxford economics professor, Simon Wren-Lewis, [7] advocated the policy for the ECB in July 2019, suggesting that the ECB could cut rates for borrowers well below the lower bound, while keeping interest rates for depositors at the lower bound. Harvard University’s and Bank of England's MPC member Megan Greene suggested that the ECB could use dual interest rates to offset an apparent weakening of the European economic outlook, citing work by the Irish economist, Eric Lonergan, which argues that the ECB’s TLTRO was the most significant monetary innovation since the Great Financial Crisis, due to the possibility of deploying dual interest rates. [8]

In the EU, a growing number of academics, bankers, and activist organisations have advocated for the ECB to introduce "green dual rates" as a means to encourage bank lending towards energy-efficiency and renewables projects. [9] [10] ECB President Christine Lagarde has repeatedly said she was interested in this concept. [11]

Concerns

The main concern with dual interest rates is the potential impact on the central bank’s balance sheet. If the interest rate at which the targeted loans are made to banks falls below the interest rate which the central bank earns on reserves, the operation would cause a decline in the central bank’s net interest income. Mario Draghi, has argued that the impact on central banks’ profitability should not be a consideration in monetary policy, what matters is the effect on inflation. Other economists have expressed concern about banks’ ability to game dual interest rates. [12]

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<span class="mw-page-title-main">Central bank</span> Government body that manages currency and monetary policy

A central bank, reserve bank, national bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base. Many central banks also have supervisory or regulatory powers to ensure the stability of commercial banks in their jurisdiction, to prevent bank runs, and in some cases also to enforce policies on financial consumer protection and against bank fraud, money laundering, or terrorism financing. Central banks play a crucial role in macroeconomic forecasting, which is essential for guiding monetary policy decisions, especially during times of economic turbulence.

<span class="mw-page-title-main">European Central Bank</span> Supranational central bank in Europe

The European Central Bank (ECB) is the central component of the Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important central banks with a balance sheet total of around 7 trillion.

<span class="mw-page-title-main">Federal Reserve</span> Central banking system of the US

The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.

<span class="mw-page-title-main">Monetary policy of the United States</span> Political Policy

The monetary policy of the United States is the set of policies which the Federal Reserve follows to achieve its twin objectives of high employment and stable inflation.

<span class="mw-page-title-main">Monetary policy</span> Policy of interest rates or money supply

Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability. Further purposes of a monetary policy may be to contribute to economic stability or to maintain predictable exchange rates with other currencies. Today most central banks in developed countries conduct their monetary policy within an inflation targeting framework, whereas the monetary policies of most developing countries' central banks target some kind of a fixed exchange rate system. A third monetary policy strategy, targeting the money supply, was widely followed during the 1980s, but has diminished in popularity since then, though it is still the official strategy in a number of emerging economies.

In macroeconomics, an open market operation (OMO) is an activity by a central bank to exchange liquidity in its currency with a bank or a group of banks. The central bank can either transact government bonds and other financial assets in the open market or enter into a repurchase agreement or secured lending transaction with a commercial bank. The latter option, often preferred by central banks, involves them making fixed period deposits at commercial banks with the security of eligible assets as collateral.

<span class="mw-page-title-main">Federal funds rate</span> Interest rates to maintain banks Federal Reserve balance in the U.S.

In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate is an important benchmark in financial markets and central to the conduct of monetary policy in the United States as it influences a wide range of market interest rates.

<span class="mw-page-title-main">Lender of last resort</span> Government guarantee to provide liquidity to financial institutions

In public finance, a lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market when other facilities or such sources have been exhausted. It is, in effect, a government guarantee to provide liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general.

In the United States, federal funds are overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the federal funds market enable depository institutions with reserve balances in excess of reserve requirements to lend reserves to institutions with reserve deficiencies. These loans are usually made for one day only, that is, "overnight". The interest rate at which these transactions occur is called the federal funds rate. Federal funds are not collateralized; like eurodollars, they are an unsecured interbank loan.

<span class="mw-page-title-main">Money creation</span> Process by which the money supply of an economic region is increased

Money creation, or money issuance, is the process by which the money supply of a country, or an economic or monetary region, is increased. In most modern economies, money is created by both central banks and commercial banks. Money issued by central banks is a liability, typically called reserve deposits, and is only available for use by central bank account holders, which are generally large commercial banks and foreign central banks. Central banks can increase the quantity of reserve deposits directly, by making loans to account holders, purchasing assets from account holders, or by recording an asset, such as a deferred asset, and directly increasing liabilities. However, the majority of the money supply used by the public for conducting transactions is created by the commercial banking system in the form of commercial bank deposits. Bank loans issued by commercial banks expand the quantity of bank deposits.

The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.

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Quantitative easing (QE) is a monetary policy action where a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary policy that came into wide application after the 2007–2008 financial crisis. It is used to mitigate an economic recession when inflation is very low or negative, making standard monetary policy ineffective. Quantitative tightening (QT) does the opposite, where for monetary policy reasons, a central bank sells off some portion of its holdings of government bonds or other financial assets.

<span class="mw-page-title-main">Term auction facility</span> Temporary Program

The Term Auction Facility (TAF) was a temporary program managed by the United States Federal Reserve designed to "address elevated pressures in short-term funding markets." Under the program the Fed auctions collateralized loans with terms of 28 and 84 days to depository institutions that are "in generally sound financial condition" and "are expected to remain so over the terms of TAF loans." Eligible collateral is the same as that accepted for discount window loans and includes a wide range of financial assets. The program was instituted in December 2007 in response to problems associated with the subprime mortgage crisis and was motivated by a desire to address a widening spread between interest rates on overnight and term interbank lending, indicating a retreat from risk-taking by banks. The action was in coordination with simultaneous and similar initiatives undertaken by the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank.

The interbank lending market is a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate. A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions during the financial crisis of 2007–2008.

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References

  1. ↑ "Dual Interest rates always work, Philosophy of Money, June 2019". 5 June 2019.
  2. ↑ He, Dong (2011). "Dual-Track Interest Rates and the Conduct of Monetary Policy in China". Hong Kong Institute for Monetary Research.
  3. ↑ "Mario Draghi's policy bazooka may be his most precious legacy, Financial Times, 29 May 2019". Financial Times. 29 May 2019. The firepower of TLTROs lies in this potential for introducing a second rate.
  4. ↑ "Central banks should consider giving people money, Financial Times, 2 August 2019". Financial Times. 2 August 2019. In contrast to the other monetary innovations adopted since the crisis, dual interest rates are almost certain to raise spending and economic activity.
  5. ↑ "ECB announces new series of targeted longer-term refinancing operations (TLTRO II)". ECB press release. 10 March 2016.
  6. ↑ Barbiero, Francesca and Burlon, Lorenzo and Dimou, Maria and Toczynski, Jan, Targeted Monetary Policy, Dual Rates and Bank Risk Taking (July 1, 2022). ECB Working Paper No. 2022/2682 doi : 10.2139/ssrn.4170361
  7. ↑ "Mainly Macro". 23 July 2019. Retrieved 29 August 2019.
  8. ↑ "Time for ECB to use its monetary power, Philosophy of Money, March 2019". 28 March 2019.
  9. ↑ Van Eyck, Vicky (2024-01-09). "The ECB is wrong. Green dual interest rates are possible – and necessary". Green Central Banking. Retrieved 2024-02-05.
  10. ↑ Jourdan, Stanislas (2022-01-26). "The ECB can help fix the energy price crisis: Play the long game". Energy Monitor. Retrieved 2024-02-05.
  11. ↑ Randow, Jana (1 June 2022). "Lagarde Has Open Mind on ECB Lending as a Climate-Crisis Tool".
  12. ↑ "Targeted loans would let banks take a round trip at the ECB's expense, Financial Times, 4 June 2019". Financial Times. 4 June 2019.
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