Monetary policy implementation in a negative rate environment

Monetary Policy Implementation in a Negative Rate Environment

Michael Boutros Duke University

Jonathan Witmer Bank of Canada

June 16, 2017

Abstract

Monetary policy implementation could, in theory, be constrained by deeply negative rates since overnight market participants may have an incentive to invest in cash rather than lend to other participants. To understand the functioning of overnight markets in such an environment, we add the option to exchange central bank reserves for cash to the standard workhorse model of monetary policy implementation (Poole, 1968). Importantly, we show that monetary policy is not constrained when just the deposit rate is below the yield on cash. However, it could be constrained when the target overnight rate is below the yield on cash. At this point, the overnight rate equals the yield on cash instead of the target rate. Modifications to the implementation framework, such as a tiered remuneration of central bank deposits contingent on cash withdrawals, can work to restore the implementation of monetary policy such that the overnight rate equals the target rate.

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1 Introduction

Central banks have significantly altered their monetary policy implementation frameworks in the aftermath of the financial crisis. First, quantitative easing resulted in an increase in central bank reserves, which significantly changed trading incentives and behavior in the market for overnight reserves. In 2008, the Federal Reserve introduced interest on reserves as a way to maintain influence over the overnight rate because of a significant increase in reserves (Klee et al. (2016)). More recently, several central banks including the European Central Bank (ECB), the Swiss National Bank (SNB) and the Bank of Japan (BoJ) have adopted negative policy rates.

Central banks implement monetary policy differently, and it is not apparent how differences in monetary policy implementation frameworks matter in a negative rate environment. Most central banks operate by setting a target for the overnight interest rate, along with rates on standing facilities through which participants can borrow from or deposit with the central bank (Borio, 1997). Some central banks, like the Bank of Canada, operate a corridor system whereby the target rate is in the middle of a corridor bounded by the (higher) borrowing rate and the (lower) deposit rate (Bank of Canada, 2015). Others operate a floor system ? so named because the target rate is equal to the deposit rate at the bottom of the interest rate corridor. Some central banks have even adapted their frameworks as they lowered their policy rates into negative territory. The Swiss National Bank, for instance, has transitioned to a tiered system for the remuneration of deposits with the Swiss National Bank (Swiss National Bank, 2014). An amount of deposits with the Swiss National Bank is exempt from the negative deposit rate and is compensated at a rate of zero. Any deposits above this amount are compensated at a negative rate, meaning banks pay the Swiss National Bank for these deposits. How were these changes important for the implementation of monetary policy in a negative rate environment?

Monetary policy implementation is concerned with how short-term (usually

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overnight) interest rates are determined and is the starting point of the monetary policy transmission mechanism. Understanding the impact of negative rates on monetary policy implementation is of practical importance since negative interest rates are becoming more common. Over USD 13 trillion of sovereign bonds has now traded at negative rates (Whittall and Goldfarb, 2016). And sovereign bond yields in some countries are negative beyond ten years of maturity, suggesting that negative rates are not expected to be a passing phenomenom.

Currently, central banks with negative rates have a wide range of deposit rates, ranging from -5 bps to -125 bps (Table 1). This could reflect differences in the effective lower bound (ELB) in these countries, which could be related to differences in monetary policy implementation frameworks. It also could reflect the fact that some central banks have not yet hit their ELB, given that yields on cash may be more negative than current overnight rates. This may still be above the negative yield on cash after incorporating the costs of holding and using cash: estimates of the costs of storing and using cash could range from 25 bps (Witmer and Yang, 2016) up to 200 bps (Vin~als et al., 2016). Nonetheless, it is not clear a priori which policy rate ? the target rate, the lending rate, or the deposit rate ? must remain above the ELB.

Table 1: Negative Central Bank Rates as of November 2016 (bps)

Country

Danmarks Nationalbank European Central Bank Swiss National Bank Swedish Riksbank Bank of Japan Hungarian National Bank

Negative Rates Introduced

July 2012* June 2014 Dec. 2014 Feb. 2015 Jan. 2016 March 2016

Lending Rate 5 25 50 25 10 115

Deposit Rate -65 -40 -75 -125 -10 -5

*The Nationalbank temporarily raised rates into non-negative territory between April and September 2014.

Our paper introduces the ELB to the academic literature on monetary policy implementation by including the option to exchange central bank reserves for cash in a model of monetary policy implementation (e.g., Poole (1968); Bech

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and Keister (2013)). The opportunity to invest in cash implies an effective lower bound or constraint on overnight interest rates (e.g., Witmer and Yang (2016)), and thus presents a potential obstacle to the implementation of monetary policy. To the best of our knowledge, no other model has considered how the zero lower bound and negative interest rates can impact monetary policy implementation.

Our model contributes several new insights to this literature. First, it is the central bank target rate that must be above the ELB, not the central bank deposit rate. Intuition would suggest that the deposit rate must be above the ELB (i.e., the yield on the outside cash option), since participants would prefer investing in cash over depositing at the central bank. However, they do not have the ability to exchange cash for reserves at the end of the day after the uncertain payment shock. The marginal cost of borrowing an extra dollar in the overnight market ? the overnight rate ? is equal to the respective probabilities of accessing the two central bank standing facilities at the end of the day multiplied by their respective rates (Bindseil, 2001), with these probabilities determined by the uncertainty inherent in the payment shock and the participant's position just prior to the shock. Thus, the yield on cash does not impact the overnight rate as long as the target for the overnight rate is above the ELB. Put another way, a participant with excess funds during the day would be better off lending to participants at the target rate, rather than deposit in cash earning the cash yield, as long as the target rate is above the return on cash. Similarly, participants short of funds would not want to become even more short by investing in cash since they would have to borrow even more from other participants at the higher target rate.

Second, if the yield on cash is above the overnight target rate but below the central bank lending rate, the overnight interest rate will equal the yield on cash.1 Intuitively, participants would prefer to withdraw and invest in higher-

1When the yield on cash is above the central bank lending rate, participants would want to borrow from the central bank and invest in cash, and there is no overnight market. Participants would not want to lend their funds below a rate they receive on investing in cash, and participants would not want to borrow funds above the rate they could attain when borrowing from the central bank.

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yielding cash rather than lend to other participants at the target rate. Their cash withdrawals will lower the overall amount of reserves in the system. In equilibrium, the amount of reserves will adjust until the overnight rate is equal to the return on cash.

Third, our model is the first to examine monetary policy implementation with a tiered deposit rate that allows the tier thresholds to adjust depending on the cash withdrawals of each participant. The Whitesell (2006) model shows the conditions under which static tiered rates can be used to steer the overnight rate towards the target overnight rate in a positive rate environment.2 Our model shows how to extend this model to a negative interest rate environment by adding the option to exchange reserves for cash. As well, we also allow the tiered thresholds to vary with cash withdrawals, and demonstrate why this feature is important for divorcing the overnight rate from the yield on cash. The Bank of Japan and the European Central Bank, for example, have implemented a tiered remuneration of central bank deposits. Our model shows that it is not the tiered remuneration in and of itself that changes incentives to withdraw from the central bank; rather, it is the fact that this tiered remuneration is a function of cash withdrawals that can disincentivize these withdrawals such that the overnight rate once again equals the target rate.

Finally, we develop a model with reserve requirements that are a function of cash withdrawals. This has not been considered in the literature and has not been implemented by any central bank in the negative rate environment. Within our model framework, we show that a varying reserve requirement is more powerful than a varying tiered remuneration in disincentivizing cash withdrawals. This stronger disincentive occurs because, with some probability, banks may not be fully utilizing their exemption threshold in a tiered remuneration framework, so a change in this exemption threshold has a less powerful effect on their

2Different methods have been proposed and utilized for determining the size of the threshold. Whitesell (2006) suggests that the central bank could set the price of the threshold amount and sell this threshold amount for a fee (e.g., 5 bps of the total size of the quota). Holthausen et al. (2008) propose that the central bank could set the quantity of the threshold, and either determine these limits in the same way as they currently determine reserve requirements, or auction the limits to participants.

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incentives. Thus, according to our model, a varying reserve requirement will better help a central bank maintain its influence over the overnight rate when rates are potentially constrained by the lower bound.

Our paper is related to the literature that examines the impact of frictions on monetary policy implementation since the ELB is a friction that can impact the ability of a central bank to influence the overnight interest rate towards its policy rate. Several papers consider how regulation, and in particular the liquidity regulation of banks, will affect monetary policy implementation and the functioning of money markets (Bech and Keister (2013), Banerjee and Mio (2014), Bonner and Eijffinger (2012), Rezende et al. (2016)). Others examine the effect of search frictions, which can generate predictions about volumes and volatility of overnight rates (Bech and Monnet, Afonso and Lagos (2015), Armenter and Lester (2015)). Another related set of papers also considers how segmentation in the overnight market and differential access to central bank facilities can have an impact on monetary policy implementation (Williamson (2015), Bech and Klee (2011), Armenter and Lester (2015), Martin et al. (2013)). Several of these papers show how the introduction of new tools, such as the Federal Reserve's overnight reverse repurchase facility (ORRP) and term deposit facility (TDF) can work to attenuate the effects due to segmentation. Similarly, we show how alterations to the monetary policy implementation framework can attenuate the impact of the ELB on overnight interest rates.

Since we are examining the ELB, our paper also complements the strand of the literature that analyzes the effect of unconventional tools such as quantitative easing and the resulting large central bank balance sheets and excess reserves on the determination of the overnight interest rate. Kashyap and Stein (2012), for instance, point out that when the central bank has large excess reserves it essentially has two tools: the interest it pays on reserves, as well as the quantity of those reserves. They suggest that the central bank then has the capability of pursuing two objectives: an inflation objective, and an objective to reduce the externalities created by excessive short-term debt issuance

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by financial intermediaries. Some recent papers discuss how these tools can be used in the exit from unconventional monetary policy (Bech and Klee (2011), Armenter and Lester (2015), Ihrig et al. (2015)). The ELB may limit the ability of the central bank to adjust one of these tools (the interest on reserves), and our model examines how adjustments to implementation frameworks may work to restore this ability.

Given this, it also relates to recent papers that suggest how the ELB could be lowered or removed. If the central bank restricts conversions of reserves to cash or increases the aggregate stock of paper currency according to a pre-defined rule, a market-determined deposit price of paper currency may develop even if the central bank is still exchanging reserves for cash at par (Goodfriend, 2016). Goodfriend argues that this could, in theory, help to overcome the lower bound on interest rates. However, it may also require changes such that contracts are enforced to be paid in deposits rather than paper currency (Agarwal and Kimball, 2015). Similarly, the central bank could charge a time-varying paper currency deposit fee to eliminate the incentive to withdraw cash to avoid negative interest rates (Agarwal and Kimball, 2015). In our model, an adjustable system of tiered remuneration can also reduce this incentive to withdraw cash. It shows how such an adjustable tiered remuneration could be used to reduce the friction associated with the lower bound, at least to a certain degree.

In the next section, we provide the details of our basic model before examining equilibrium impacts in section 3. Section 4 provides a numerical example to illustrate how the model would work in practice. We consider modifications to our basic model in section 5. In particular, we focus on how a tiered remuneration of central bank reserves (such as is implemented by the Bank of Japan) can work to mitigate the impact of the ELB on the overnight market. We conclude with a short discusion in section 6.

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2 The Model

We employ a static model similar to the one in Bech and Keister (2013). Perfectly competitive banks are profit maximizers that must respect a reserve requirement determined by the central bank, which could in fact be zero.

A bank begins the day by observing its own holdings of liabilities and assets, including the amount of reserves it holds and its reserve requirement. Next, the bank can increase (decrease) reserves by borrowing (lending) on the interbank market or can decrease reserves by converting them to cash. The bank faces uncertainty with regards to the optimal amount of interbank borrowing and lending because after the interbank market closes, the bank uses its reserves to continue allowing deposits and withdrawals from customers.

At the end of the day, the bank determines if the new level of reserves meets the reserve requirement set by the central bank. If its reserves are lower than its reserve requirement at the end of the day, the bank borrows directly from the central bank at a rate of rX . Likewise, any reserves in excess of the requirement are deposited with the central bank at the end of the day at a return on excess reserves rate rR. Poole (1968) shows (under reasonable assumptions) that borrowing from the central bank is essentially always more expensive than borrowing on the interbank market.

The model's timing is similar to other models of monetary policy implementation, with the exception that it includes an opportunity to exchange reserves for cash during the day. Our results depend on the timing of the reserve-cash conversion. For example, if commercial banks could exchange reserves for cash after their deposit shocks are realized, the equilibrium interbank rate would be very different. In essence, if the return on cash was greater than the central bank deposit rate, commercial banks would not use the deposit facility and would instead earn the return on cash. The equilibrium rate would then be determined by the return on cash and the central bank borrowing rate, the same way it is determined by the central bank deposit rate and borrowing rate in the standard

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