Many central bank officials have been trying all sorts of conditioning narratives to convince us…
Why banks are pushing the US central bank to increase interest rates
A few weeks ago I wrote – US Federal Reserve decision correct – there is no ‘normal’ – and suggested that the reason Wall Street and other well-to-dos were busily invading the media at every opportunity berating the US central bank for not increasing interest rates was because they had a vested interest in rates rising. They massage their call for higher interest rates in terms of global concerns for inflation (mostly) but just below the surface (they are mostly pretty crude in their advocacy) is the real reason – their own profit bottom line improves. On October 1, 2015, the Bank for International Settlements published its Working Paper no. 514 – The influence of monetary policy on bank profitability. The research demonstrates my very point. They find that when the short-term interest rate rise (that is, the policy rate set by the central bank) “bank profitability – return on assets” also rises. They also find that this “effect is stronger when the interest rate level is lower”. The overall conclusion is that “unusually low interest rates … erode bank profitability”. So forget all the spurious arguments about inflation risk etc that the financial media (who are really just ghost writers for the top-end-of-town) write ad nauseum. The real reason the Wall Street lobby keeps pushing for rate hikes is because they want more profit.
The BIS paper notes that monetary policy (setting the policy interest rate target) “has a major impact” on the so-called interest rate structure, as the:
… central bank sets the short-term rate and influences longer-term rates through direct purchases of securities and by guiding market participants’ expectations about the short-term rate.
The interest rate structure or the yield curve describes the linked rates that apply to different assets across the maturity range – short-term, medium-term and long-term.
The term ‘yield curve’ is often used to describe the 3-month, 5-year and 30-year US Treasury debt and is then used to provide a guide (benchmark) against which the private debt instruments (mortgages, bank lending, etc) can be assessed.
Observers also use the ‘yield curve’ to forecast movements in economic activity. So a flattening moving to an inverted yield curve – where the longer rates fall relative to the shorter-term rates (and eventually become lower) – signals that the ‘markets’ believe a recession is nigh.
Please read my blog – Operation twist – then and now – for more discussion on this point.
The BIS paper seeks to study whether there is a “negative effect of a low interest rate structure on bank profitability and hence on the soundness of the banking sector”.
There is a relative scarcity of research in this area. The limited extant literature shows that:
1. “high real interest rates are associated with higher interest margins and profitability” particularly when banks can pay “below-market interest rates” on deposits.
2. “a significant relationship between net interest rate income and the yield curve slope”.
3. “a steep yield curve raises interest margins”.
The specific question they explore is:
… the link between monetary policy and bank profitability … focusing precisely on the relationship between the interest rate structure and bank performance.
How might monetary policy affect the slope of the yield curve?
First, “central bank controls the short- term rate quite closely through the policy rate” – that is unequivocal.
Second, the central bank then exerts “indirect” influence on the yield curve. This happens via “market participants’ expectations about the future policy rate path … and through large-scale operations in government securities specifically intended to have an impact on their price”.
So next time you read some deadbeat economist or his/her financial media lackey, claim that higher fiscal deficits push up interest rates because they drain scarce savings from the financial markets, you should note – the central bank controls the short-term interest and all the rest of the rates largely follow suit.
In effect, the central bank sets the interest rates at the short-end of the yield curve and the term structure follows expectations of inflation risk rather than default risk.
The “balance sheet” operations of the central bank can then control any other interest rate at any maturity that the bank desires. How?
The central bank could announce, for example, a ceiling on a longer-term yield, which was below the current market rate if it wanted the longer-term – investment rates – lower.
It could enforce that aim by being prepared to purchase the targetted assets at the desired yield.
Mainstream economists repeatedly claim that this strategy would have to be ratified by the market for it to work. That is, the only way the central bank could cap yields on longer-term assets is it the target yield was consistent with the market expectations of the yield.
Which, of course, is pure nonsense. These economists mostly use so-called ‘frictionless financial market’ models where there is no time or transaction costs and everyone has perfect information and equal access. That is, they count angels on the top of pin heads.
Clearly that sort of model has nothing to say about the real world we live in.
The only consequence of a discrepancy between the targeted yields and the market expectations of future yields would be that the central bank would end up holding all of the targetted asset and the bond traders would not buy at all because they thought yields would have to rise and bond prices fall.
My assessment of that outcome – excellent.
The bond traders might boycott the issues and ‘force’ the central bank to take up all the volume on offer. So what? This doesn’t negate the effectiveness of the strategy it just means that the private buyers are missing out on a risk-free asset and have to put their funds elsewhere. Their loss!
Eventually, if the government bond was the preferred asset the bond traders would learn that the central bank was committed to the strategy and would realise that if they didn’t take up the issue the bank would. End of story – the rats would come marching into town piped in by the central bank resolve.
The BIS paper concurs that the central bank holds all the cards in this regard.
They also argue that “attempts to influence the yield curve have become much more prominent as a means of providing extra stimulus” since the crisis.
This relates to Quantitative Easing which has driven down longer-term rates in the hope that they will stimulate borrowing although the media was told, initially, that it was to put more cash into the system so that the banks would have more funds to loan out.
The latter depiction of QE was, of course, nonsensical. Please read my blog – Quantitative easing 101 – for more discussion on this point.
The BIS argue that “both the level of interest rates and the slope of the yield curve are associated with higher net interest income”. They mean higher levels of interest rates and steeper yield curves.
The BIS say that the interest rate level effect is due to four separate “mechanisms”:
1. a “retail deposits endowment effect” – bank deposits are set lower than “market rates” – because of bank sector concentration etc. As market rates drop, the gap between the two “becomes smaller” and so a tighter monetary policy (higher policy rates) will “increase net interest income”.
2. a “‘capital endowment effect’ – “equity capital does not pay interest” and “as interest rates fall, the return on assets covered by capital mechanically declines”.
3. a “quantity effect” that counterbalances the ‘price effect'” – borrowing is more sensitive to interest rates than deposits so that when interest rates rise, profitability falls.
This assumes wrongly that banks need deposits in order to make loans. The correct depiction of the banking system is that loans make deposits and the banks get the necessary reserves to cover the loans afterwards.
4. “the dynamics of transition between equilibria, including repricing lags and credit-loss accounting” – banks have market power and this means that “deposit rates adjust more sluggishly than lending rates”. So, “banks make profits when the monetary policy stance” tightens.
Further on (4), the lags can mean that higher borrowing at low interest rates will appear, initially, to “boost net interest margins”. But the losses “normally materialise only a few years later”.
In terms of the slope of the yield curve, the BIS claim that:
1. “a steeper yield curve should have a positive effect on banks’ net interest income” because interest rates are higher at the investment end of the curve.
2. Changes in the slope have influence “the volume of banks’ fixed-rate mortgages”. But as the slope steepens, “the demand for mortgages” declines relative to deposits and that “would erode profitability”.
What about the impact on non-interest income? In general, the BIS suggest the impact of interest rate increases on non-interest income is negative.
One example they provide is that “higher interest rates should generate losses on banks’ securities portfolios” as investors move out of shares.
Higher rates also impact on “loan loss provisions” because they “boost the default probability on the existing stock of variable-rate loans” and “induce less risk-taking on new loans”.
Given “the stock of variable-rate loans is bound to be considerably larger than the flow of new loans, the overall impact on provisions should be positive, depressing profitability”.
This will be “especially high at very low interest rates” given the latter are usually only applicable in times of financial crises or stress.
That was a brief summary of their theoretical considerations and apart from where I noted concerns, the reasoning is fairly uncontroversial.
They form a number of conjectures (“testable hypotheses”) that they explore:
1. A positive relationship between the level of interest rates and the yield curve slope and bank profitability.
2. A negative relationship to non-interest bank income.
3. A positive relationship between the level of interest rates and the yield curve slope and loan loss provisions.
4. A positive relationship between the level of interest rates and the yield curve slope and “overall bank profitability”.
I will leave it to you to investigate the research design.
They have a sample that includes “all major international banks” from 1995 to 2012. So the sample is rich because it covers different stages of the economic cycle and different interest rate settings as a consequence.
There are a number of manipulations they make which I won’t discuss here. None are particularly controversial nor likely to distort the underlying sense.
The substantive conclusions are:
1. There is “a positive relationship between the interest rate structure and bank profitability”. What drives this result?
2. “the level of short-term interest rates and the slope of the yield curve are positively associated with banks’ net interest income, reflecting their positive effect on bank margins and on returns from maturity transformation, respectively” and “higher interest rates boost loan loss provisions … and depress non-interest income, most probably because of their negative impact on securities’ valuations”.
3. “the impact on profitability declines with the level of interest rates and the slope of the yield curve, ie that there are significant non-linearities. This indicates that the impact of interest rates on bank profitability is particularly large when they are low.
Overall, their results support the conclusion that “low interest rates and an unusually flat term structure erode bank profitability”.
I could take exception to several parts of the paper but that would divert us from the conclusion that I agree with – that low interest rates are bad for private banks and that is why there is so much pressure building on the US Federal Reserve to increase rates.
Of course, in a nationalised banking sector, such concerns would be moot.
Transfield and the University of Newcastle
There was a report today in the Australian Financial Review (October 4, 2015) – Transfield to be questioned by Sam Dastyari’s tax inquiry – which discussed the Australian Senate Inquiry into tax avoidance and the strategies employed by Transfield Services to aggressively minimise taxes through a complex “subsidiary structure”.
A member of the Senate Committee indicated that the government should “ensure bidders for large government contracts meet best-practice tax standards”.
As I explained in this blog – Universities should operate in an ethical and socially responsible manner – Transfield Services was awarded the contract from the Australian government to run the so-called “‘welfare and garrison support services’ offshore” on Manus Island (in March 2014). It has held the Nauru contract since the centre there was re-opened in August 2012.
Australia has a policy of mandatory detention of refugees including young children in harsh prisons that they have created on Nauru and Manus Island (in Papua New Guinea).
There were violent riots in February 2015 at the Manus detention centre and a 23 year old Iranian refugee, Reza Berati was murdered, allegedly by officials overseeing the centre.
A Senate Inquiry (a different one) into the abuse of refugees imprisoned on these islands under Australian government policy found extensive evidence of sexual and other physical abuse of the refugees, declining mental health, and asylum seekers are forced to live in “mould-infested, substandard and unsafe living quarters” which are administered by Transfield Services.
My own university has just entered into a controversial procurement contract with Transfield Services for it to manage university property and cleaning etc.
There is a growing staff and student protest against this decision for obvious reasons.
It should be escalated given that the AFR reported today that the:
Transfield Services’ chairman Diane Smith-Gander has hit back at activists who want the company to stop providing services to asylum seekers on Nauru and Manus Island, saying their focus on the contractor is “misplaced”.
She made the following extraordinary defence of her company:
We’re an Australian company delivering services within the frame of a policy of the Australian government that has bipartisan support and we do not influence government policy in this area … So we think the activists’ attention to us is misplaced … If they want to change government policy, they should engage directly with the government.
While the gravity of the human abuse in these prisons has not come to the end that the German government inflicted on its extermination camp inmates, this defence by the company is equivalent to saying that the companies that provided Zyklon B (Degussa, Degesh, IG Farben and Th. Goldschmidt AG) and the distributors (Heli and Testa) were not implicated at all in the Holocaust.
They were just supplying products into the market place in accordance with government policy. It was the Nazis that were at fault not the capitalist machine that supported them.
The trials for war criminals after the war didn’t agree with the defence and company principals were executed or imprisoned “for knowingly providing Zyklon B to the SS for use on humans”
The Federal Immigration Minister who oversees the human rights abuses also attacked the activism that has led to a number of large Superannuation companies divesting themselves of Transfield Services’ shares. He said that “this sort of political activism has no place in the Australian marketplace”.
But that is just the point. Allegedly, neo-liberals believe in so-called ‘consumer sovereignty’ which is this quaint notion in mainstream microeconomics textbooks which claims all resource allocation decisions are ultimately the outcome of consumers voting with their dollars!
If a company is misbehaving or providing bad products then the marketplace will sort it out as consumers desert the products.
So it is perfectly reasonable for us to impose costs on firms that deliver bad products in the hope they will cease.
In fact, in this blog – Time for progressives to adopt more direct actions – that is exactly what I advocated.
Finland, October 2015
I am visiting Finland between October 7-11, 2015 and will be giving a number of presentations and talks during those four days.
1. Thursday, October 8, 2015 – SOSTE Talk 2015.
SOSTE is the “Finnish Federation for Social Affairs and Health is a national umbrella organisation that gathers together 200 social and health NGO’s and dozens of other partner members.”
I am their guest and I will be speaking at their annual conference – SOSTE Talk. The topic will be on Full Employment and how governments can achieve it.
I will be speaking between 9:00 and 10:30.
2. Thursday, October 8, 2015 – Austerity and Beyond – University of Tampere
After a 90 minute train trip from Helsinki to Tampere I will be speaking at the University of Tampere on the theoretical and political background of Eurozone austerity. There will be two discussants and a free conversation to follow.
The presentation and discussion will run between 15:00 and 18:30. All are welcome.
The location is Tampereen yliopisto (University of Tampere), Kalevantie 4, 33014 Tampereen yliopisto Tampere, Finland.
For more details E-mail: firstname.lastname@example.org
3. Friday, October 9, 2015 – Guest Lecture at University of Helsinki – Economic Austerity and the Alternatives.
The Topic will be similar to the discussion at the University of Tampere although I will branch out and discuss Modern Monetary Theory (MMT) undoubtedly.
There will be two discussants and an open discussion to follow.
The event is free and open for everyone. It is organized by the Finnish Society for Political Economy and the Department of politics and economics, University of Helsinki.
The Finnish Karl Marx Society has promised to organise a good quality video broadcast from the event which will be available on YouTube soon afterwards.
The event will run from 17:00.
The location is Unionikatu 40, 00170 Helsinki, Finland.
Newcastle, NSW – October 2015
I will be speaking at the Workshop – “Pushed to the Margins: a conversation about poverty and inequality in our community” on Wednesday 21st October, 5.30-7.30pm, Newcastle City Hall, Concert Hall.
Join ABC Lateline’s Emma Alberici and a panel of distinguished local and national speakers as they explore the realities of poverty and inequality in our community, its causes, impacts and how collectively we can bring change. A conversation guaranteed to enlighten, engage and stimulate. One time only – an opportunity not to be missed!
- Dr John Falzon, CEO, St Vincent de Paul Society National Council
- Kelly Hansen, CEO, Nova for Women and Children
- Prof Bill Mitchell, Director, Centre of Full Employment and Equity, University of Newcastle
- Sue Cripps, CEO, SC Consulting Group and founding CEO Homelessness NSW
- Dr Clare Hogue, Senior Researcher, Hunter Research Foundation
This is a free event – all welcome! Register at http://pushedantipoverty.floktu.com/
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.
This Post Has 12 Comments
Their seems to be a fundamental problem with this analysis.
As central bankers are predominantly private bank men through and through
why have they not acted on behalf of the banks and raised interest rates?
“banks are pushing the US central bank to increase interest rates”
can you provide a few specific examples of where banks have directly communicated this?
(apart from anything that might have been emitted from their economic research divisions, which are quite separate from and do not have the same internal information as the executive management of bank risk positions)
I’m not saying they haven’t, but I haven’t noticed anything significant along these lines
Search Twitter, one banker compared low rates policy to the Bataan Death March. Look at opeds in WSJ, use google.
Bill, Have you forwarded your analysis through to Janet Yellen?
I’m sure she would appreciate some support. She’s certainly not getting it at home!
Thanks for coming back to this Professor. So it really is that the spread between what banks can charge on the loans they make and the costs they incur in that process just gets squeezed in a low interest rate setting.
I suppose it is possible that private banks don’t make as much profit with low interest rates although they still seem to be doing OK. But of course,greed is infinite.
But low interest rates also encourage the uptake of reckless private debt. The 2007/2008 melt down demonstrated the dangers of that and not for the first time.
There should be a sort of Goldilocks zone for interest rates. Maybe our brilliant economists could devote some time to that little problem.
Glad that you are going to give a talk in Finland. I am in Estonia but can’t make It to hear you. I hope there is going to be video materials later on. I would be particularly interested in the reaction of the mainstreamers. Finland’s economy is not doing so good after Nokia’s fall out and they insist on austerity now. During FIM they had somewhat similar experience when Soviet Union broke up, they devalued their currency then. Now that option is gone, so even fixed exchange rate is better than the euro nightmare.
You might like to read The natural rate of interest is zero for an idea of what MMT typically considers to be the “Goldilocks zone”. The basic idea is that fiscal policy is used to regulate and stimulate the economy because it is more direct, and can deal with distributional issues, such as targeting different regional zones, whereas monetary policy is seen as a blunt instrument with a lag between policy setting and effects. So in the absence of a support rate, interbank competition is left to push the overnight rate down to zero.
On the issue of what you refer to as “reckless private debt” arising out of a low policy rate, there are several issues which I understand as contributing factors:
1) Fiscal drag arising from insufficient government spending, i.e, austerity;
2) Declining or stagnating real wages over the past several decades;
3) Deregulation of the financial sector allowing banks to take advantage of points 1 & 2;
So I wouldn’t assume that a low policy rate is causative of reckless private debt.
Several comments here from bankers at the Barclays conference calling for rate hikes and threatening layoffs.
“But low interest rates also encourage the uptake of reckless private debt. ”
Regulate what loans can be used for then, and make any loan outside that criteria unenforceable (i.e. a gift of shareholder capital).
That’s what ‘asset side discipline’ means. And it is required because liability side discipline is ineffective in an endogenous system. Price doesn’t discipline bubbles.
Thanks a lot for this post.
I found the remark that banks set the deposit rate lower than the “market rate” particularly interesting given that the main argument against low central bank interest rates in the German mainstream media boils down to “savers don’t get any interest on their deposits, punishing the sensible, parsimonious everyman”.
Dosen’t the Fed realise the rentiers are hurting 🙂