A new acronym has entered the lexicon of central banking in recent months – NIRP, which stands for negative interest rate policy. If ZIRP, zero interest rate policy, won’t stimulate faster growth in nominal spending and faster growth in the prices of goods and services, then perhaps central bank-engineered negative short-term interest rates will do the trick. In June 2014, the European Central Bank (ECB) introduced NIRP and the central banks of Switzerland, Denmark, Sweden, and Japan have recently done so as well. For the most part, NIRP involves a central bank paying a negative rate of interest on a portion of reserves or deposits held by private depository institutions (mainly commercial banks) by the central banks. One purpose of NIRP is to encourage banks to make more loans by penalizing them with a negative nominal return on ‘excess’ reserves held by the central bank. Another purpose of NIRP is to achieve a lower structure of real (inflation-expectations adjusted) interest rates. After all, if the yields on short-maturity interest rates are at zero and investors expect deflation, then the real yields on these securities would be positive. (The real yield is the nominal yield minus inflation expectations. If the nominal yield is zero and inflation expectations are negative, i.e., deflation is expected, and then zero minus a negative number result in a positive number.) If nominal aggregate demand is growing at a sub-optimal rate, then a lower structure of real interest rates would likely cause the quantity of bank credit required to increase, which if the credit were granted would, in turn, cause growth in aggregate demand to increase. NIRP is a remedy for insufficient demand for bank credit.
Read Will the US Go Negative in 2017?
But if growth in nominal aggregate demand is sub-optimal because of an insufficient supply of bank credit, then NIRP will not be effective in remedying the situation. If banks do not have the capital to support their acquisition of more loans and securities with credit and interest rate risk, then charging these banks a ‘storage fee’ for reserves held at the central bank will not induce them to create more credit. It will do the opposite. The extra expense charged banks by the central bank for reserves storage will reduce bank profits, inhibiting growth in the bank capital necessary to allow banks to increase their acquisitions of loans and securities.
This post was published at FinancialSense on 03/08/2016.