Home Views Global Economy

Tame inflation without subsidising banks

Paul De Grauwe and Yuemei Ji
Paul De Grauwe and Yuemei Ji3/2/2023 11:46 AM GMT+08  • 5 min read
Tame inflation without subsidising banks
Photo by Kenny Eliason on Unsplash
Font Resizer
Share to WhatsappShare to FacebookShare to LinkedInMore Share
Scroll to top
Follow us on Facebook and join our Telegram channel for the latest updates.

Major central banks have been raising interest rates aggressively to tackle inflation woes. But a byproduct of the recent rate hikes is higher interest payments on central-bank deposits held by commercial banks – a transfer of public-sector money to private banks.

The Eurosystem – comprising the eurozone’s 20 national central banks and the European Central Bank (ECB) – will pay EUR107 billion ($153.2 billion) in interest (on EUR4.3 trillion of deposits) to financial institutions during 2023. As promised, that number will increase to EUR129 billion when the ECB raises its deposit rate to 3% in March.

In the US, the Federal Reserve (Fed) recently voted to raise the interest rate paid on reserve balances to 4.65%. That means it will owe US$140 billion ($188.2 billion) in interest payments on roughly US$3 trillion of bank reserves this year. The Bank of England is also on the hook for similarly massive handouts to commercial banks.

The latest monetary-tightening cycle implies profits for commercial banks and financial losses for central banks, raising anew the question of whether commercial banks should be remunerated for holding reserves at the central bank. Is paying interest on reserves necessary to conduct monetary policy? Or can central banks raise interest rates without giving massive handouts to commercial banks?

While many economists take it for granted that bank reserves earn interest, the practice is recent. The ECB introduced interest payments on excess reserves when it started its operations in 1999, and the US Congress authorised the Fed to do so in 2008. Before 2000, the general practice was not to pay interest on bank deposits.

In fact, commercial banks do not pay interest on demand deposits, even though these deposits provide liquidity for the real (non-financial) economy. Why should bankers be paid for holding liquidity while everybody else should accept not being remunerated?

See also: Briefs: World 'way off-track' from climate goals; Sembcorp weighs sale of waste management unit

The lack of a genuine economic basis for paying interest on reserves becomes even more apparent when one considers how central banks make their profits: By obtaining a monopoly from the state to create money. Paying interest to commercial banks amounts to transferring monopoly profit to private institutions. But that profit is essentially taxpayers’ money, and it should be returned to the government that has granted the monopoly rights rather than funnelled to commercial banks.

Still, many economists believe that remunerating bank reserves is necessary to conduct monetary policy nowadays. After all, major central banks face an overabundance of reserves owing to years of quantitative easing. Because of this oversupply, the interest rate is stuck at 0%, and the central bank cannot raise the market interest rate (which it needs to do to fight inflation).

According to conventional wisdom, central banks can only push up rates in such an environment by paying interest on the ocean of reserves held by credit institutions. Since commercial banks will not lend in the interbank market at an interest rate below the risk-free deposit rate, the latter acts as a floor for the market interest rate. Higher deposit rates then feed through to the entire structure of interest rates.

See also: Hong Kong opens doors to billionaires in family office push

But there are other ways for a central bank to drive market interest rates higher without transferring its profits to commercial banks. For example, it could sell government bonds, a form of quantitative tightening that major central banks are already implementing.

The problem is that shrinking a central bank’s balance sheet is very slow. It could take more than a decade for the volume of bank reserves to reach pre-2008 financial crisis levels. A temporary increase in minimum reserve requirements should supplement bond sales.

The ECB has chosen not to use this instrument to date, maintaining the current reserve requirement at 1%, while the Fed has abolished the requirement entirely. But policymakers should reconsider the issue. As central banks gradually pared back their holdings of government bonds, minimum reserve requirements could likewise be steadily reduced.

By transforming the excess reserves held by commercial lenders into required reserves on which no interest is paid, central banks could recreate the system that existed before the financial crisis. At that point, the scarcity of reserves would mean that small manipulations in the supply of reserves could change the money market rate without central banks paying interest on deposits.

Some object to using minimum reserve requirements because it amounts to a tax on banks and could result in economic distortions. But all taxes introduce distortions; the real question is whether the gains outweigh the costs.

The advantages of minimum reserve requirements are twofold. First, the authorities can eliminate the distortion created by providing massive subsidies to banks. Second, policymakers gain an exceptional policy tool designed to take a big bite out of a central bank’s balance sheet while maintaining financial stability.

Central banks can increase interest rates without massively subsidising banks. Their profits should once again be transferred to governments. Taxpayers, not banks, should benefit from public-sector money. — © Project Syndicate

Paul De Grauwe is Chair of European Political Economy for the European Institute at the London School of Economics. Yuemei Ji is an Associate Professor of Economics at the University College London

Loading next article...
The Edge Singapore
Download The Edge Singapore App
Google playApple store play
Keep updated
Follow our social media
Subscribe to The Edge Singapore
Get credible investing ideas from our in-depth stock analysis, interviews with key executives, corporate movements coverage and their impact on the market.
© 2022 The Edge Publishing Pte Ltd. All rights reserved.