The problem with negative real interest rates

The “Taylor rule” is representative of a large school of macroeconomic thought which takes the view that monetary policy-makers should set the policy rate as a function of the inflation rate and the unemployment rate (or an alternate measure of economic slack).  Those who have been schooled in this framework have difficulty understanding why anyone would recommend raising the policy rate when inflation is extremely low and the economy is weak.

Monetary policy is viewed as a “neutral” policy because it works through interest rates.  As long as the big banks pass changes in the policy rate on to borrowers, then all participants in the economy are able to benefit from any decreases in the policy rate and to face the costs of any increases.  Fiscal policy by contrast will always favor some beneficiaries of the government’s largess over others, and thus cannot be considered “neutral”.  It should be noted, however, that the neutrality of monetary policy depends on the competitive structure of the monetary transmission mechanism and if the banks that trade in the federal funds market, where policy rates are set, do not always pass on changes in the policy rate, monetary policy will act as a subsidy to the big banks.  In fact, it is my view that when the policy rate approaches the zero lower bound — and real interest rates are negative — the incentive for financial intermediaries to arbitrage their negative cost of funds distorts lending markets and the monetary transmission mechanism.

Models that support the use of a Taylor rule rarely specify the structure of the financial system explicitly.  And I think that the best way to understand them is that they express a very simple view of financial intermediation along these lines:  A vast number of the transactions that underlie economic activity are dependent on the extension of credit — many firms depend on short-term credit to finance working capital and on long-term finance to make large scale projects possible and most consumers are dependent on credit to finance large purchases like homes and automobiles and other consumer durables.  For this reason a decrease in the interest rate tends to reduce the cost of financing transactions and by reducing their cost increase the number of transactions — and it is of course these transactions that are used to calculate GDP.  The role of financial intermediaries in this process is to hold as deposits the income received by the consumers (who also staff the firms) and sales receipts of the firms and recycle those deposits into the loans — at an interest rate sensitive to the policy rate — that allow this economic activity to take place.  In short, the model is based on old-fashioned banks that (i) hold loans on their balance sheet — and because they carry long-term exposure to these loans underwrite them very carefully and (ii) set interest rates on the loans they offer in a competitive market.

There are many historical time periods in which this simple model of financial intermediation is accurate enough.  However, the drive towards profitability in the financial system has a tendency to generate a process of financialization in the economy.  A multi-tiered financial system is created in which banks lend to other financial intermediaries who in turn lend to other financial intermediaries or the real economy.  One of the most common consequences of this process is a reduction in the capital supporting the issue of loans.  In fact the profitability of the multi-tiered system is generally driven by the fact that more loans can be issued with a given capital base.  (It is precisely because there are norms for bank capital requirements that a new kind of intermediary has to be created.)

Some examples of this process are the bill-brokers of mid-19th century England, who are discussed in detail by Walter Bagehot, and whose role in the financial system was greatly reduced after the failure of Overend and Gurney in 1866.  In the early 20th c US, trust companies and investment trusts were important vehicles for financialization — until the reforms of the ’30s forced a return to “plain vanilla” banking.

Of course another wave of financialization has taken place over the past few decades and it is this multi-tiered financial structure that interferes with the simple operation of the Taylor Rule.  Modern banks don’t hold the loans they originate, but instead either sell them off — to for example an asset backed commercial paper conduit — or finance them on the repo market.
(i)  Because the loans are not carried on the balance sheet, but instead have their value realized at the date of origination, the immediate value of the loan becomes more important than the life-long value of the loan.  This is an environment which is primed to issue as many loans as possible.  Furthermore,
(ii) Each tier of the financial system is profiting from an interest rate spread and when nominal interest rates are below the rate of inflation, economic incentives push these intermediaries to borrow as much as possible and finance as many loans as possible.  While, in theory, these should all be “good” loans with little risk of credit loss, (i) ensures that the incentives are not necessarily aligned to guarantee the quality of the loans.

Another aspect of modern financialization is that financial intermediaries are able to use their borrowed funds to trade on secondary markets — an act that has traditionally been prohibited for banks.  Thus, the unlimited demand for funds created by negative real interest rates is easily channeled into purchases on secondary markets.  The natural consequence of this process is that negative real interest rates tend to drive up the value of risk assets like stocks and junk bonds.  Of course, to the degree that the demand for these assets is driven by the negative cost of borrowing, normalization of interest rate policy will necessarily have the effect of reducing demand for these assets and the value of risk assets.  Thus, negative real interest rates will tend to create increases in the prices of risk assets that are unsustainable over the long-run.

In short, in an environment where new financial intermediaries have been created that attenuate the relationship between deposits and loans, negative real interest rates create an unlimited demand for funds by the financial sector which can easily flow into loans of dubious quality and markets for risky assets as intermediaries gamble on their ability to successfully arbitrage the negative cost of funds.  This view implies that in an economy with a multi-tiered financial system the Taylor rule needs to be adjusted for the additional economic costs created by a policy rate that falls below the rate of inflation — and that as we near the zero bound the optimal policy rate will be significantly higher than that implied by the Taylor rule.  On the other hand these concerns will not necessarily apply to an environment where a law like Glass-Steagall (i) restricts the activities of financial intermediaries in a way that protects the profitability of simple commercial banks, while at the same time allowing for interbank competition, and (ii) precludes the flow of funds borrowed by intermediaries into secondary markets.

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