How dual interest rates can give central banks an unlimited capacity to combat recessions when the policy rate runs out of steam.
By Will Rojas
Traditionally when a recession hits, a central bank’s first move is to lower policy interest rates. This targets the loan rate between commercial banks, which in turn sets the lending rate for the rest of the economy. However, in recent decades this has been more difficult to do. As interest rates have naturally fallen, central banks must keep low target rates just to maintain current economic conditions. When the COVID-19 pandemic hit, the Fed target rate was already 2.5%, leaving little room to lower it before hitting the zero lower bound, which is the rate at which investors cease to be incentivized to lend and instead park their money in cash accounts. This led to the widespread use of nontraditional monetary policy tools like quantitative easing, in which the Federal Reserve pledged to purchase over $500 billion in assets over the course of the pandemic in order to keep treasury yields low, spur inflation, and provide liquidity to the market. However, quantitative easing by itself is not a substitute for lowering the policy rate and it provides credit to institutional investors who in turn might not pass on their gains to individual consumers. This is where dual interest rates come in.
The policy of dual interest rates is the practice of setting the discount rate—the interest rate at which the central bank offers loans to commercial banks—and the deposit rate—the interest rate the central bank pays commercial banks on their reserves held in the central bank—separately. Historically, the discount and deposit rates have been shifted with changes in the policy rate. This means if the policy rate is set too low, the deposit rate, which influences individual consumers’ deposit rates on their accounts, will subsequently drop and may disincentivize consumers from keeping money in their bank account, especially if that rate is negative. This system created a zero-sum game between borrowers and lenders: as rates increased and provided more favorable conditions for lending, borrowing became more expensive, and vice versa. With dual interest rates, central banks can offer loans with low, and even negative, rates to commercial banks, encouraging them to turn and lend at low rates, while the deposit rate can be kept the same or raised. This allows the interest rate for lending to be lowered and the interest rate on consumers’ bank accounts to be raised simultaneously, causing both institutional investors and consumers to gain while increasing net wealth in the economy.
To further increase the effectiveness of dual interest rates, targeted loans can be used, providing credit to commercial banks on the condition they target certain kinds of recipients for their loans. The European Central Bank did this in 2016 with the introduction of the Targeted Longer-Term Refinancing Operation (TLTRO). Under this program, the interest rates on loans to commercial banks are decided based on the degree to which they loan to non-financial institutions and households (except for mortgages): the more they lend, the lower the interest rate they receive. When COVID-19 hit Europe, the ECB policy rate was already negative, leading the ECB to add dual policy rates (the first time this was explicitly done by a central bank) to the already-launched TLTRO III. This let the ECB encourage economic growth without hitting the zero lower bound and credit running dry.
Dual policy rates, especially when combined with targeted loans that ensure the credit’s economic productivity, have theoretically unlimited use. Loan rates to commercial banks can always be lowered without fear of consumers withdrawing their funds as long as deposit rates are maintained. However, the central bank must cover the difference between the amount received on interest from loans to banks and given in interest to banks for their deposits. If this difference becomes too great, central banks will have to create too much money and can raise inflation to undesirable levels. However, in today’s environment of chronically low inflation, it doesn’t appear this will be a real issue any time soon. □
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