Alberto Polo
Could the slow response of deposit rates to changes in monetary policy strengthen its impact on the economy? At first look, the answer would probably be ‘no’. Imperfect pass-through of policy to deposit rates means that the rates on a portion of assets in the economy respond by less than they could. But what if this meant that the rates on other assets responded by more? In a recent paper, I develop a model that is consistent with a number of features of banks’ assets and liabilities and find that monetary policy has a larger effect on economic activity and inflation if the pass-through of policy to deposit rates is partial.
Empirical evidence on banks’ assets and liabilities
Using United States data, I estimate local projections of deposit rates, deposit balances and other bank assets and liabilities to high-frequency changes in US monetary policy. I highlight three effects which follow an increase in the monetary policy rate:
- Deposit rates increase substantially less, reaching +0.07 percentage points after one year for a 0.25 percentage point increase in the policy rate (Chart 1, Panel 1).
- Deposit balances held at banks decrease (Panel 2) and banks partly substitute lost deposits with other debt.
- Various spreads between the interest rate paid on a credit instrument and the risk-free rate increase – in particular for interbank borrowing and mortgages (Panels 3 and 4).
Chart 1: Responses to a 0.25% increase in the monetary policy rate
Standard models used to analyse the transmission of monetary policy to the economy are at odds with these facts. Therefore, I develop a model that can explain them, with imperfect pass-through to deposit rates at its core.
A theoretical model
For the model to hope to match these data, it needs to include households, banks, a central bank that sets the policy rate and some frictions that allow interest rates on different assets to respond differently to monetary policy changes.
To this end, I extend a standard dynamic stochastic general equilibrium (DSGE) model with housing to include banks that collect funds from saver households through short-term deposits and bonds, and lend to borrower households in fixed-rate mortgages. Banks have market power on deposits and set deposit rates to deliver stable profits and dividends over time. Deposit demand depends on current and past deposit rates, as is the case in markets where customers repeatedly purchase the same product. Finally, as banks finance a larger share of their assets through bonds, the rate they have to pay on bonds increases above the monetary policy rate. This friction captures the feature that banks have a limited pool of non-deposit borrowing available, and that this source of funding is less stable than deposits. Therefore, lenders to banks would require compensation for the higher rollover risk a bank takes when it finances a larger share of its assets through non-deposit debt.
Intuition and results
The model relies on a novel mechanism that generates imperfect pass-through to deposit rates. It explains the response of mortgage and interbank spreads that I document empirically, as well as the response of deposit rates and balances. The model eventually reveals that lower pass-through to deposit rates amplifies the effect of monetary policy on economic activity.
When the monetary policy rate increases, the cost of banks’ short-term debt increases. While new mortgages price in the higher level of rates, mortgages issued before the rate change have their rate locked in – at least in the short run.
Hence, banks face a trade-off. If they increase the deposit rate as much as the policy rate, they lose profits. If they keep the deposit rate low, banks experience an outflow of deposits, as depositors prefer to earn a higher rate by investing their savings elsewhere. This is especially costly for a bank if current and future deposit demand are related – which is the case given that depositors have a low probability of switching banks, and once a depositor is lost, it is difficult to re-attract them. In the end, banks decide to increase the deposit rate partially, smoothing their profits without losing an excessive amount of deposits.
As deposits flow out, banks still have to finance their assets, thus they substitute deposits with other debt. The substitution generates an increase in the rate banks have to pay on non-deposit debt – above and beyond the level of the rate controlled by the central bank. Eventually, banks pass the higher rate they face on non-deposit debt to the rate on new mortgages.
Without imperfect pass-through to deposit rates, these effects disappear. Depositors would not have an incentive to look elsewhere for higher returns as interest rates rise, and banks would not need to substitute deposits with other debt. Hence, the response of the mortgage rate to the increase in the policy rate would be smaller. As the mortgage rate increases less if pass-through to deposit rates is full, demand for mortgages contracts by less and so do consumption and output. This is shown in Chart 2, where the fall in output after an increase in the policy rate is smaller if pass-through to deposit rates is full (in yellow) than if it is partial (in green). As covered in the underlying paper, inflation also decreases less if pass-through to deposit rates is full.
Chart 2: Output response to a 0.25% increase in the policy rate
Policy implications
While the result may be counterintuitive, it shows that analogous findings across counties in the United States extend to the level of the entire economy.
Accordingly, understanding the impact on deposit markets of regulation, or changes in competition, appears increasingly important in order to understand the transmission of monetary policy to the economy. For instance, reforms that reduce switching costs for depositors would increase competitive pressure on banks to move deposit rates in line with the policy rate, leading to fuller pass-through. If this were the case, banks would not need to replace deposits with other debt when interest rates rise, reducing the amplification mechanism I identify.
Alberto Polo works in the Bank’s Monetary Policy Outlook Division.
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