Is micromanagement all that is left among the monetary policy tools?

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Once exclusively the domain of bakers and a sign of confectionary prowess, tiering may be becoming a central banking convention and a new feature among the unconventional monetary policy tools. Today’s conundrum for central banks is increasingly how to simultaneously preserve something of commercial banks’ net interest-rate margins (NIMs) (and thereby their profitability) and use negative interest rates as part of their efforts to fan growth and inflation. If, when reading this last sentence, the expression ‘having it both ways’ came to your mind, then yes, that is what we are talking about.

 

What is the big idea?

By imposing negative interest rates on commercial bank deposits at the central bank – effectively charging banks for the pleasure of leaving their excess cash safely with the monetary authority – the central bank seeks to dis-incentivise this practice. It would rather see commercial banks seeking a profitable use for the money. How? By lending it to companies and households, thus stimulating demand, inflation and economic growth. That’s the theory.

The catch?

Banks see no opportunity to step up lending given the generally lacklustre levels of investment and consumption. This leaves them stuck with excess cash. But depositing it at the central bank now costs money. To date, many banks have taken the hit of these negative rates and not passed them on to retail depositors. Hence recent investor concerns about the profitability of banks.

 The answer?

Turning the thumb screws on banks by cutting already negative rates further is an option, but a potentially more painful and risky one. This is where tiering can come into play. On 29 January, this is how the Bank of Japan (BoJ) – not the first central bank to introduce negative interest rates and tiering, but the most recent and most talked-about example – addressed the issue.

Tiering à la Japonaise

Japan’s central bank split the current account balances that financial institutions keep at the BoJ into three tiers (see exhibit 1). Existing balances continue to earn a positive 0.1%. Reserves that institutions must keep at the BoJ and the reserves related to the central bank’s various lending support programmes earn no interest. On any reserves not included in the first two tiers, a negative rate of -0.1% would be charged. The BoJ said the three-tier system should prevent “undue decreases in financial institutions’ earnings.”

However, ‘tiering à la Japonaise’ to shield banks from the full impact of negative rates would arguably defeat the purpose of these penalty rates – forcing banks, and by extension, investors out of safe parking places into risky assets. It could also further raise market suspicions that the central bank was pursuing measures aimed solely at weakening the currency.

Exhibit 1: Tiering à la Japonaise – the Bank of Japan has adopted a three-tier system concerning interest on reserves held by commercial banks at the BoJ

boj

Source: Bank of Japan policy statement published on 29/01/2016

Next in line: the ECB? Not among its monetary policy tools this time

In the face of eurozone growth at best holding steady while (more) deflation looms, it was no surprise that on 10 March, the ECB increased the penalty rate it charges lenders for excess deposits by 10 basis points (bp) to minus 0.40%.

While such a move could weaken the euro, thus supporting exports and have a desirable macroeconomic effect, market talk ahead of the ECB decision had centred on the even more negative impact that a steeper penalty rate would have on commercial bank profitability, sending bank shareholders running for the exits.

To tackle this dichotomy, the ECB opted for a raft of counterbalancing measures including a 5bp cut in the refi rate to 0% and in the rate on the marginal lending facility to 0.25% respectively. The package included four four-year refinancing operations (TLTRO II) for banks. The rate charged could be “as low as the interest rate on the deposit facility,” the ECB said.

So, while the ECB did not opt for a tiered deposit rate system, this may only be a question of time. On 10 March, president Mario Draghi appeared to suggest that rates are now at the lower bound. It’s probable that he was deliberately ambiguous to keep his options open – if the ECB’s current focus on ‘alternative’ measures does not bring results, more negative rates accompanied by tiering to cushion the blow may return to the agenda of the governing council.

In addition, the ECB continues to emphasise the need for action to stimulate growth and encourage inflation, echoing the G20 appeal for other policies, notably fiscal and structural reforms. But it also pointed out the limitations to their implementation. These include the EU’s Maastricht rules and the EU ban on central banks monetising public debt.

How useful is it to try to be all things to all men?

It appears fair to say that while the ECB did not go for the balancing act that tiering involves – à la Japonaise or otherwise – it still sought to offset the effect of a deposit rate cut, in this case by offering banks cheaper central bank financing. At the same time, this approach too could leave investors with the same doubts about the effectiveness of current monetary policy.

If we study the market’s reaction in the shape of the movements in the euro/US dollar exchange rate on 10 March, we see that:

  • Initially, in very volatile trading, the euro weakened to the lowest rate since early February at around USD 1.08 (see point 1 on exhibit 2) on the ECB’s headline measures.
  • Subsequently, after Mario Draghi’s comments that further rate cuts may not be necessary and that rates are now at the lower bound, the euro staged a powerful rally (see point 2 on exhibit 3). Over the course of 10 March, euro/dollar swung across a 4% range, ending the day up by almost 2%. The rally has continued, with the Federal Reserve’s decision on 16 March to hold off on further rate hikes providing further impetus. This would not appear to be in alignment with the ECB’s declared reflationary intent.

Exhibit 2: euro/ US dollar fluctuates wildly as foreign exchange markets react to the ECB’s announcements on 10 March (euro/ US dollar for the month to 17/03/2016)

euro usd

Source: Bloomberg, 17 March 2016

Did the BoJ do any better?

It does not look that way. The reaction in the currency markets to the Bank of Japan’s tiering policy (see exhibit 2) suggests that even such sophisticated tiering – fine-tuning by another name – does not enable central banks to ‘have it all their way’. Despite the BoJ’s introduction of negative interest rates, the Japanese yen has rallied strongly versus the US dollar.

Exhibit 3: Backfiring: despite the BoJ’s introduction of negative rates on a specific tier of deposits, the Japanese yen has rallied (rate for the month to 17/03/2016)

yen usd

Source: Bloomberg, 17 March 2016

So, for the moment, it would appear that tiering and ‘high-wire’ monetary policy tools will not enable central bankers to have it all their way. Spurring lenders into lending more while preserving their margins/profitability and encouraging savers to spend cash rather than sit on it is a difficult circle to square, as the BoJ now well knows.

Stay posted for further news of either successful monetary policymaker micromanagement for macroeconomic purposes or the next instalment of a huge ‘monetary policy experiment’. [divider] [/divider]

This article was written on 18 March 2016, in Amsterdam.

Nieck Ammerlaan

Senior web content editor & investment content writer

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