Zero Lower Bound on Deposit Rates and Transmission Mechanism of the Negative Interest Rate Policy

Abstract

There have been heated debates on the negative interest rate policy (NIRP) since it was first introduced in major economies. Critics argue that deposit interest rates cannot break through the zero lower bound (ZLB) and that banks’ interest margins can be heavily squeezed under the NIRP. The underlying rationale is that deposits are the source of funding for banks. In this paper, we argue that in the modern credit money system, banks create deposits by making loans, and not the other way around. Deposit rates can be sufficiently negative without hurting banks’ profitability or curbing credit supply. We use a dynamic stochastic general equilibrium (DSGE) model to demonstrate the quantitative importance of ZLB on deposit rates in the transmission mechanism of monetary policy. Simulation results show that the ZLB on deposit rates heavily impede the transmission mechanism of the NIRP, which might explain the limited effects of the NIPR in the Euro Area and Japan. If banks are willing to expose retail depositors to negative interest rates, the effectiveness of the NIRP will be greatly strengthened and central banks should adopt deeply negative interest rates during a deflationary recession. The transmission mechanism of an NIRP has not been exactly the same as conventional interest rate cuts. Banks’ profitability is still a major concern, and the central banks that implement the NIPR only take modest action. Negative interest rates have not reached retail depositors and the effects of the NIRP are limited. We present a DSGE model to show that sticky deposit rates have impeded the transmission channel of the NIRP. This result explains the limited effects of the NIRP in Japan and the Euro Area. We challenge the prevailing view that banks cannot pass on negative policy rates to retail deposits. If the interest rate pass-through to deposit markets is complete, the NIRP is very effective in boosting credit growth and inflation. Given that natural interest rates in advanced economies have stayed low, central banks may resort to the NIPR more often in the future. When the ZLB is no longer a constraint, to raise the inflation target, as heatedly debated, is not a necessary move anymore.