When policies clash - ZIRP and deposit insurance premium

It is surprising that policies within a single government may clash, or at least that is what you should expect. The left hand should know what the right is doing. Unfortunately, that may not be the case with central banks. Perhaps this is a good reason why central banks should have only one policy directive.

The Fed is following a zero interest rate policy (ZIRP) in an effort to increase aggregate demand. In fact, the policy is actually to force real rates negative. Simple enough. But if investors deposit money in a bank, the bank has to pay for deposit insurance which could be between 5-7 bps. This means that it could actually cost banks money to have new deposits.

Think about this, you offer the depositor a rate and then lend out the money at a slightly higher rate which will allow you to gain the spread. But the spread will have to cover the deposit insurance so that you will have to offer money at a higher positive spread. If you do not have good lending opportunities, you could actually lose money on new deposits.

Deposit insurance is not free, but regulation can impede the ability of banks to lower rates and still make a profit. Regulation on bank capital, which is needed, can also impede lending and hurt aggregate demand. So what are the right policies? It is more than forward guidance.