March 8, 2016
NIRP – No Need to Go There
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/or 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) at 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 at 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, then zero minus a negative number
results 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 demanded 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.
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/or 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.
The remedy for an insufficient supply of bank credit is
an increased supply of a close substitute, central bank credit. This is what
the central bank policy of quantitative easing (QE) is all about – providing an
increased supply of central bank credit to supplement an insufficient supply of
bank credit due to banks’ inadequate capital.
The “gas” that inflates an asset-price bubble is credit. When the
asset-price bubble bursts and asset prices deflate, the lenders who were
providing the bubble-inflating credit suffer losses, which depletes their
capital. If banks have provided significant amounts of the bubble-inflating
credit, either directly or indirectly, then when the bubble bursts they will
suffer losses that could inhibit their ability to extend new credit. What’s
more, typically after an asset-price
bubble has burst, the financial regulators impose higher capital requirements
explicitly and implicitly on banks. If banks are capital constrained and
central banks do not pursue an effective QE
policy, growth in nominal aggregate demand will remain anemic.
Let’s go to the charts. Plotted in Chart 1 are quarterly
observations of total financial assets minus reserves held at the central bank
(primarily loans and securities) for private depository institutions in the US
and the Euro area. I have converted each series to an index number (with the
Q4:2008 levels equal to 100) for ease of comparison. For US private depository institutions,
non-reserves assets did not return to their Q4:2008 level until Q4:2013. But by
Q3:2015, these assets on the books of US private depository institutions were
at an index level of 110.7 or 10.7% above their Q4:2008 level. Initially,
non-reserves assets at Euro-area private depository institutions increased
until the end of 2011. After declining through the end of 2013, then rebounding
in 2014, non-reserves assets at Euro-area private depository institutions stood
at a level only 0.1% higher than they were in Q4:2008. In sum, over this almost
7-year period, non-reserves financial assets at US private depository
institutions grew at a compound annual rate of just 1.5% while these assets at
Euro-area private depository institutions, for all intents and purposes, showed
no growth, on net.
Chart 1
Now let’s see what the Fed and the ECB did to augment the
anemic amount of credit created in this period by private depository
institutions. Plotted in Chart 2 are the index levels of the sum of Fed
financial assets plus US private depository institution financial assets less
reserves at the Fed. Let’s call this sum, total thin-air credit. (Everyone may now knock back a shot.) Also
plotted in Chart 2 are the index levels of non-reserves financial assets at US
private depository institutions. Wow! What a difference a central bank can make
in creating thin-air credit to compensate for weak credit creation on the part
of private depository institutions. By Q3:2015, total US thin-air credit stood
36.3% above its Q4:2008 level, representing a compound annual rate of growth of
4.7%. Although 4.7% pales in comparison to the 7.6% compound annual growth in
total thin-air credit in the 55 years ended 2007, it still is a heck of a lot
stronger than the 1.5% compound annual growth in credit created by US private
depository institutions alone from Q4:2008 through Q3:2015.
Chart 2
Now let’s look at these data for the Euro-area. Plotted
in Chart 3 are the index levels of the sum of ECB financial assets plus
Euro-area private depository institution financial assets less reserves at the
ECB or total Euro-area thin-air credit. Also plotted in Chart 3 are the index
levels of non-reserves financial assets at Euro-area private depository
institutions. This chart contains data through Q4:2015 whereas data in previous
charts ran only through Q3:2015. The reason for this difference is that the ECB
has released Q4:2015 data while the Fed will not do so until March 10. Taking
into consideration Q4:2015 data, Euro-area total thin-air credit grew at a
compound annual rate of only 0.7% from Q4:2008. But if the ECB had not provided
thin-air credit via various lending facilities to depository institutions and
belatedly via QE, the change in Euro-area thin-air credit would have been even
more anemic. When Q4:2015 is included, credit provided by Euro-area private
depository institutions actually contracted,
on net, vs. Q4:2008.The conclusion is that the ECB was late coming to the QE
party and brought too little party “punch”.
Chart 3
So, let’s review. In the seven years following the global
financial crisis of 2008, credit created by private depository institutions in
both the US and the Euro-area, on net, has been anemic, if at all. Immediately
after the crisis, the Fed created massive amounts of temporary credit to the US
private depository institution system as well as non-depository financial
institutions via loans. Soon thereafter, the Fed engaged in three separate
rounds of QE that resulted in net Fed purchases of securities of $3.7 trillion in the 24 quarters ended
Q4:2014. In contrast, the ECB has engaged in only one round of QE, which
commenced in Q4:2014. In the five quarters ended Q4:2015, the net change in
securities on the books of the ECB was only about $631 billion at current exchange rates. So, the Fed’s QE operations
started earlier than the ECB’s, persisted on and off for a six-year period, and
were cumulatively much larger.
Now, let’s see which economy has experienced faster
growth in nominal domestic demand. This is shown in Chart 4 where the index
values of Gross Domestic Purchases for the US and the Euro-area are plotted. In
the 28 quarters from Q4:2008 through Q3:2015, Euro-area nominal Gross Domestic
Purchases increased at a compound annual rate of just 0.9%. In the 28 quarters
from Q4:2008 through Q4:2015, US Gross Domestic Purchases increased at a
compound annual rate of 3.0%.
Chart 4
The ECB will have a monetary policy meeting on March 10.
It is likely that a more aggressive NIRP will be discussed. If the goal of the
ECB is to stimulate growth in nominal domestic demand, it should not waste its
time considering or implanting NIRP. Rather, go with what has “worked” for the
Fed. The ECB should pursue an aggressive and persistent QE policy such that the
sum of ECB credit and Euro-area
private depository institution credit grows at some “normal” rate. Despite the
success of QE by the Fed in stimulating growth in US nominal domestic demand,
many a talking twerp is discussing the necessity of NIRP to bring the US
economy out of its next recession. First, why worry about the next US recession
when there is none on the horizon? Second, if QE worked to help get the US
economy out of its worst recession since the early 1930s, why don’t you think
it will work in producing a recovery from the next US recession, whenever it
may come?
Note: On the off chance that you have questions or
comments to which you desire my reply, please email me directly. You, of
course, are free to post comments or questions on my blog page and/or on my
LinkedIn page. However, I seldom visit these pages except to post a new
commentary.
Paul L. Kasriel
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI
Founder and Six Sigma Director of Econtrarian, LLC
1-920-559-0375
