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Why Interest Rates on Savings Accounts Are Still So Low

Published Feb 23, 2023, 9:00 AM

The Federal Reserve has been raising benchmark borrowing rates at the fastest pace in decades, but the interest rate paid out to millions of people with bank accounts is still stuck at almost zero. According to data from Bankrate, the average interest rate on savings accounts is just 0.23%. So what's going on? Why have many banks so far avoided raising what they pay out to depositors even as the Fed hikes, and will that eventually change? What does it mean for the financial system and also economic policy given that higher rates are, in theory, supposed to encourage less spending and more saving in order to curb higher inflation? On this episode, we dig deep into the making of bank deposit rates with Barclays strategist Joe Abate.

Hello, and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway and I'm Joe. Wasn't all Joe? Do you know what the average interest rate paid on US bank accounts currently is? Holy? Because we just looked it up and I couldn't blow it. I actually thought you were wrong about as like I thought when you told me the number that you must be a despel point off. Yeah, it is surprising. So the average annual percentage yield er ap Y according to bank rate is point two three percent. And this at a time when, as you know, benchmark interest rates are at like four and a half four point seven five percent. I would have guessed that maybe they were like one and a half. Two percent was just still pretty low, right, So if you could get four and a half percent as a bank an overnight rate, and then it was like, okay, your saving your depositors, check your account whatever, you get a couple percent that's still spread, but they're still basically paying you nothing. I just want to like hold your cash there, which is pretty staggering. Absolutely, So this is a question that comes up a lot, and it's obviously frustrating. If you are a saver, you know, it's very everyone wants to be a rentier to some extent, right, I'll want to make money on our money exactly. That is the dream. So if the banks aren't passing through those interest rate hikes, it's naturally frustrating for retail depositors. However, it's also kind of frustrating from an economic slash macroeconomic policy perspective, because if you think about what monetary policy is supposed to do, it is supposed to work through changes in interest rates, which are supposed to ripple out from the central bank into the rest of the economy. Right intuitively, like one channel that you could imagine that rate hikes work through is oh, look suddenly I'm getting a lot more money, to say, or getting more Maybe I'll at the margin, I'll save a little more because I'm getting paid to spend a little less, create sort of decreased pressure in the economy. I don't know if anyone ever really thinks that way. It's like, oh, I'm not going to buy like this watch, or I'm not going to buy these like a concert tickets because I could get you know, three percent having left this money in the bank. Nonetheless, we have to get point two three percent. I'm definitely gonna okay, I'm definitely going to keep spending in that case. And of course there are ways to like get more yield and you could lock it up, but if you wanted to, you could go out, like buy a one year CICA of deposits. Wo's not going to do that, you know, You're not, Okay, it's so much to work. Okay, Well, this is clearly something that we need to talk about, both in the context of monetary policy and yes, broader economics. And I am very pleased to say that we really do have the perfect guest on this topic. We're going to be speaking with Joe Abote. He is a money market strategist over at Barclay's also does fixed income research. I've been a fan of his work for a very long time and happened meaning to get him on all thoughts for just as long. So I'm very pleased to have him here now to explain this discrepancy to us. Joe, welcome to the show. Thank you. Nice to hear. Yes and no. I think I think the fundamental problem with bank deposit rates is that there's so many different types of deposits, and because there's so many types of deposits, it's hard to kind of come up with one comparable interest rate across all banks and across all forms. Right, So you have deposits a time, deposits for example, CDs that you just mentioned, You've got checking account rates if they pay interest at all, and then you've got you know, different balance requirements for different types of customers and things like that. So coming up with an explicit, one size fits all bank deposit rate is difficult. But the phenomena that you're describing where bank deposit rates in a rising rate environment go up like a feather, and in a interest rate cutting environment where the Fed is easing policy, they sink like a stone. That's been a phenomena for decades. Well, let's get into that then. So you know the FED hikes rates on a Wednesday. Why doesn't that just automatically translate to a bunch of banks emailing savers and saying your deposit rate is going up? And I know there are a couple that do seem to automatically raise saving rates, but it's not the norm. Well, the question boils down to kind of what does the bank need right in terms of financing? Right, So most of its funding comes from deposits, and banks have a fair amount of pricing power when it comes to deposits, right, there's not many substitutes for bank deposits out You might try a money market fund, for example, or you might try, you know, bills or like some of the things that you were talking about, but you're not going to get the same level of liquidity, for example, with deposit insurance that you might with a bank deposit. And so if you're not faced with a lot of competition, and I'm talking about industry wide, then deposit rates don't necessarily have to go up lockstep with the increase in the fent funds rate. So to your point, you know, it's not terribly surprising that deposit rates don't go up immediately when the FED raises rates. Now, I will say that they do go up, and the real issue is not so much the level of rates, but the speed with which they go up, right, And that becomes a question of what people call the deposit data, which is how much of the monetary policy rate or the change in the FED funds rate actually gets passed on to depositors. And what happens is that initially in the tightening cycle, banks are over deposited, and as those deposits migrate into higher yielding products and they lose financing, they start to compete more aggressively with each other and they start to try to poach deposits from one institution to the next. And what you see is with subsequent rate heights, the deposit data right goes up. And so what you normally find is that in the last tightening cycle, for example, the pass through effect was only about thirty five to forty of the rate heights made it into bank deposit rates over the entire cycle. But if you started at the cycle, it was down around ten percent, and by the end of the cycle it was closer to seventy five or eighty percent. And that has happened, you know, pretty much every interest rate cycle going back decades, which is start low and high, but that the overall deposit beta for the cycle is somewhere around thirty to forty of the Fed's rate ings. And again, this is a competitive dynamic, right. There's not a lot of substitutes for deposits out there, right that offer the same level of deposit insurance or protection and liquidity. Then you know, banks have a significant degree of pricing power when it comes to deposits. So Joe, just on that note, this idea that eventually deposit rates do go up as the competitive process between banks kind of kicks in. One piece of interesting research that I saw from the New York Fed is this idea that deposit betas so the relationship between you know, benchmark rates and what banks are actually paying savers that they have been trending lower in later interest rate cycles. So the beta now is lower than it was in say like the early two thousands hiking cycle. It's lower than it was and sort of the most recent hiking cycle as well. What accounts for that? You know, if I had to spect you that, I'd say that there's probably two things that may account for it. One is that Kewey has kind of changed to the dynamics so that banks, you know, at the beginning of a tightening cycle are significantly more over deposited than they were in past tightening cycles. And that might account for why deposit betas are lower, because banks have a thicker cushion of deposits, and therefore they don't have to compete as readily as they did or as quickly as they did back in earlier tightening cycles. The second thing, which I think doesn't get as much attention right is the fact that I think banks increasingly, especially the larger domestic institutions, are not competing specifically on explicit interests. And I think what happens is that banks are able to pay people, especially institutions, with services, and rather than compete on interest rate, they compete on price services. So they may offer discounts, you know, volume discounts, if you want to think about it, and that that dynamic where you've got competition occurring through you know, kind of a non price mechanism, a non interest price mechanism, may alter how datas perform a tightening cycles. So I think that's probably I think those are probably the two main reasons why deposit datas are not as high as they were in previous cycles. So could factors like the quality of an online app, the size of the network, the ease of the website, the interconnectedness of a big banks website with payment apps like zell and other things like that, Like could Lease essentially be selling points where just bank X. I won't name any specific banks because I don't know the details. Bank excess look we have this great app, we have this great integration with all these things. Are you really going to move your you know, eight thousand dollars checking account over to why for one extra bank? Why for one extra percent? It's going to be like, you know, fifteen dollars extra a year and all the has to details. Yes, I think that. I think that's exactly right. I would also say that there's a time tax involved too, right, which is kind of the corollary of this, which is that your paycheck is linked directly to your checking account and you know, migrating it to a different bank requires you know, kind of contacting HR or probably filling out online forms at your office to kind of change the direction. And that's a hassle. And I think the hassle effect is probably what keeps deposits sticky, as well as the service effect that you mentioned, right, the non non price services. I would suspect that the effect is actually bigger for institutional deposits than it is for retail depositors. Right, that institutions obviously face much bigger costs switching banks. In addition to other non price services, which might include investment banking advice or things along that nature. That make deposits a little bit more sticky at the institutional level as well as it's a retail level, so it's not just retail but also institutions. Right, if you're a treasurer for a large company, I can imagine that there's a whole process to changing your preferred bank. Right. You know, Tracy and our producer Dash, I'm not going to say which one, but they're both customers of a certain large banks fintech arm and they're also talking about always talking about like the juicy interest rates they're getting on their checking accounts. But it does seem like kind of a hosshold. So yes, it is more money, but I don't really want to deal with it. What you know, when we talk about competition, what about sort of like classical ideas about market structure in terms of the number of banks, the size of the banks, the rise of like a handful of these mega national banks, and does that play and you roll in the sort of decline and deposit betas over time. You know, I'm not an industry analyst at that level. You know, we do have a lot of banks in the US, and there is definitely a convenience factor to location. So hard to know how that plays out, at least in my mind in terms of deposit concentration. But deposits are definitely concentrated in the US at the largest banks. I will say that now again, is that because of the stickiness of those banks, or the convenience or their online services or their network effects. I suspect it's a variety of everything. So one thing I wanted to ask is, you know, the way sort of retail deposits are supposed to work is you give the bank money, they pay you some interest, and the interest is coming from I guess the array of central bank facilities nowadays, but also from the bank taking your money and lending it out into the wider economy. So to what degree our bank deposit rates also a function of the lending or investment opportunities that banks see in the market. The primary driver is going to be asset growth on the bank side, right, That determines how competitive banks have to be in deposits. And so if you think about the bank's balance sheet on the asset side, it's got essentially three types of assets. It's got loans, it's got cash that it has to maintain for regulatory purposes. At the few reserve and it's got securities holdings. Right on the liability side, most of its funding comes in the form of deposits of some kind, and there's an advantage to deposits, especially retail deposits, because as you said, they are pretty sticky, right, and the stickiness is partly a function of the services, but it's also a function of government guaranteed deposit insurance as well. In addition to that, there's wholesale funding that they can rely on. Now, whether that's commercial paper or turned financing, corporate debt, etc. These are all supplemental forms of funding that they can rely on to camp up their funding as asset growth, you know, as assets growth, and so from banks perspective, it's got to figure out and it's got to balance on the asset side the interest returns on its earning versus interest costs of raising more deposits are raising more wholesale funding, and that balancing act is really blue way Monetary policy is expected to unfold, right, Monetary policy is expected to kind of influence that dynamic. The asset side of the balance sheet determines how you decide to fund it, whether you're using deposits, which are probably the cheapest, stickiest form of funding, or whether you're using wholesale funding right, which is a little bit more expensive, more flight prone, but you know, depending on your size, may be easier to raise because you have more market access than say a smaller institution. So it becomes kind of a question of at least monetary policy becomes a question of how to banks triage between their asset growth deposit the loans securities in cash versus their liability side deposits and wholesale funding for its commercial paper, corporate bonds, other you know, kind of term financing that's available out there, and that kind of balancing is the way monetary policy is supposed to affect bank lending decisions and the transmission of the Fed's interest rate changes. Can you talk a little bit more about how retail deposits as a source of funding, their role in twenty twenty three or twenty twenty two or whatever versus the past, What is the like how would you know if we're having this conversation in the nineties or early two thousands, what is the role of retail deposits as a source of funding then versus today? Has it changed? Yeah? So what I would say is that retail deposits have actually become more important over time because of regulatory changes. So if you're called back before the financial crisis, one of the things that was happening was that banks were increasingly reliant on wholesale funding. And they went to wholesale funding because it was cheap and it was readily available. But the result of that wholesale funding reliance was that a lot of their funding became very very rate sensitive and very rate or rather very flight prone. And you can imagine an extreme situation where you're financing let's say, thirty year mortgages and you're financing them on an overnight basis in the repo market, you have a significant maturity mismatch, right where if that repo funding can't be rolled, you lose your source of financing for those mortgages. And so one of the consequences of the financial crisis when we aw that funding was as light prone as it was, particularly in these markets, regulators kind of emphasize the need for banks to a hold more liquidity, whether it's told higher cash balances at the FED right and simultaneously rely more heavily on wholesale funding on retail funding, that is deposit based funding. And so we've seen over the last really twenty years or so as a decline in the ratio of repo funding CP market funding, you know, kind of these financial instruments of short maturities and we're financing asset growth, you know, before two thousand and six, and those have been replaced by more deposit funding now. As I said earlier, initially that would be reflected in higher deposit rates. Of course, que at the time at suppress deposit rates. And if you recall that before twenty and twelve, right, we had unlimited deposit insurance on transaction fought accounts for a while, right, in order to kind of keep funding stable for banks. What's happened since then, right, as as interest rates go up, as I said earlier, banks have been able to compete on non price or non interest rate services more and the deposits have kind of remained sticky. So you have this kind of wholesale shift away from kind of wholesale funding to retail deposits. And if you want to go back even further, this looks more akin to an environment that kind of existed, you know, prior to the nineteen eighties, right, to an environment where banks were much more deposit reliant and much less relying on financial products. And if you look back, you know further, this is kind of really beckons to an era of you know, kind of pre interest rate decontrol for nineteen eighty. But again that's that's going back a lot of many, many many years now, right, So, depot sets are more important as a source of bank funding thanks to the experience of the financial crisis and post GFC regulation, and at the same time, because we've had things like que a lot of banks are simply swimming in deposits to the extent that they kind of have more than they perhaps need, which means that they are willing to allow depositors to maybe look elsewhere for better rates. They are However, some banks are losing deposits faster than other banks. Yes, I wanted you to bring this up. This is the small bank versus large bank deposit experience. And also this dovetails with a previous episode on discount lending, the discount window. I'm sorry I missed that discount window lending piece, but I think you're exactly right here, which is that the level of deposits and the level of bank reserves in the system. That is, the cash and the liquidity circulating in the system is important, but so too is the distribution of those balances across institutions. And what we're seeing is that unlike QT or quantitative tightening in twenty seventeen, the deposits are leaving right, or at least the cash is leaving small banks faster than it's leaving the large banks, and so that the smaller banks are forced to compete more aggressively in deposit markets than say they're larger banks. Now, part of this is a reflection of the fact that when QT occurred, right, deposit balance is migrated to the largest institutions out there, again because deposits are heavily concentrated, and so those banks tended to be more over deposited relatively speaking than the smaller institutions. That when the FED is braining reserves and shrinking its balance sheet, the people that have less liquidity to start off with because they had less fewer deposits, those are the institutions that are experiencing more deposit rate pressure. How do the small banks even compete? I mean, I guess rods as you say, but like, is this like going to be a permanent condition of banking. This struggle that the small banks have for deposits relative to these high, high networked large national banks. Again, you know, small banks would argue that there are you know, advantages to banking locally, and that the advantages to banking locally is, you know, your mortgage lender knows the market right, knows the housing market in your area, your commercial banker knows your business, knows your knows you personally, etc. And so there's you know, So I wouldn't say that it's inevitable that all deposits will migrate to large institutions, and large institutions will be selective and paying deposit rates. I still think that there's enough competition between large and small banks right that you know, small banks are not going away at all. But again, this deposit competition that we're experiencing right now is the aftershock of quantitative easing, right. Quantitative easing and the buying of treasury securities and mortgages again ended up putting a lot of deposits into the system as a whole. But those deposits tended to pile up faster at the larger institutions than the smaller institutions. So just on that note, and you already touched on this, but can you dig in a little bit more into what QT or quantitative tightening actually means for I guess the effectiveness of monetary policy is it does it like mechanically ramp up that competition for depositors, or does it maybe encourage some sort of substitution effect where you know, banks can I don't know, replace bank deposits with great sensitive treasuries or something like that. That's again an important distinction, and I think what you have to look at here is the demand curve or bank reserves, right. This is the liquidity that's in the system, created from quee right from the asset side of the fed's balance sheet, and these reserves are used to me int day requirements for settling payments as well as liquidity requirements for regulatory purposes that banks are required to maintain. And as the FED lets the assets on its balance sheet roll off right and doesn't replace them, so that it's balance sheet shrinks, bank reserves go down, right, and the decline in bank reserves is what forces banks right ultimately to compete more aggressively in deposit markets because they need to restore that cash position on their balance sheet. In addition to the fact that their assets growing, right, they're making loans, they need to replace that funding. The extent to which QT creates reserve pressure, right, is what creates the pressure on the FED funds rate. Right, the Fed's policy instrument and determines ultimately where the FED funds rate trades within its target band. Right. So what the FED wants to do is, if you think about the demand curve, demand curve is probably for bank reserves is probably I'm going to get this wrong concave shape, right, so it kind of caves in in the middle, and when you get to the upper part of the demand curve, right, you're in the steep slope. The steep slope of that demand curve means is that changes in the level of bank reserves creates significant changes in interest rates. And the goal, right from the Fed's perspective, is merely to shift the supply of bank reserves so that it's in the gently sloping part of the demand curve. Right, that the level of bank reserves is ample, right, but not abundant. An ample means that it's not scarce, right, so that the level of the Fed funds are a relative to other market rates or within the band. Right, it's comfortably in the middle. Right. Remember, the Fed is is targeting a twenty five bases point band between the top and the bottom of the Fed funds rate, and the goal is to kind of keep the Fed funds rate, you know, within the midpoint, let's say, of that band, right or close to that midpoint. So again, you want to stay away from the steep part of the demand curve. But it's the same respect right, unless you're you know, substantial easing policy and you've pushed rates to zero. You also want to stay away from the super platform of the demander right where you've got bank reserves and access. At four trillion dollars, interest rates are totally unresponsive to the level of liquidity in the system because you've effectively driven rates to zero. Right. So again that's that's kind of a long winded way of describing what the goal of QT is, Right, create enough pressure on interest rates but not too much. How do you have an estimate for how small the fit is going to shrink its balanchid ultimately? So, uh, this is pretty complicated, and I think you have to be pretty humble, we should ask what the level of ample excess reserves is too, just to get all the all the loaded questions out there, all right, So my sense is that the level of ample reserves is probably around two point seven trillion dollars. But I'm a little bit cautious about that because I think the level of reserves is less important than the ratio of reserve balances is to the total cash total assets that banks have. So that if you look at twenty nineteen, when we saw all that bank reserves got too thin, we saw that going back to our demand curve, right, the ratio of bank cash assets to total assets strength below eight percent. So the eight percent mark is kind of the threshold that divides ample from scares, and so my senses, you want to keep bank reserves in terms of ample around eight percent or higher. Right at the moment, they're around nine percent. If you break that number down between domestic banks and small banks, right, you see a very different picture. Right, domestic banks, that ratio is around ten and a half percent, and they're probably still two percentage points or more away from that twenty nineteen level where they were scarce. If you look at small banks, they're around six percent sense, and that's much closer to where they were in twenty nineteen. So as we were talking about before, you know ample, right, in an aggregate sense, you would definitely say that bank reserves are ample, But in a relative sense, in terms of the distribution between large and small banks, it's not clear that there's as much ampleness of bank reserves than the numbers suggest. I just have one more question, which is, you know, in the interests of I guess, both financial stability and the effective transmission of monetary policy and fighting inflation, should we all be going out and finding the best deposit deals for ourselves. Should we all be moving our money around? Is this helpful? Yeah? I mean everybody wants to earn more money, so I would expect that people would migrate their balances to hire yielding products. And the closest substitute for bank deposit at this point is a money market fund. And the curious thing is that money market funds are not experiencing inflows, right, So money market fund balances are paying about four percent or more in terms of seven day yields, right, So you can definitely earn more than the twenty three basis points you mentioned right in a government only money market fund. And what's puzzling, at least to me, is that, given that difference between what you can earn a money market fund and a bank deposit, right, why aren't money fund balances going up? Right? Why aren't they significantly higher than they are right now? And I suspect right that there are two reasons for this, right. One is that on the retail side, we are seeing some level of interest rate sensitivity, but people are moving into higher yielding products than government only money market funds. And in fact, what they're doing is they're moving into prime money market funds. And the prime money market funds won't go into this sort of the details, but they buy commercial paper and other credit instruments right, all short maturity, but they earn a little bit more than a government only money market fund. And so if you're an interest rate since it's investor right, and you're looking for higher yields, you're going to migrate into the prime funds. And what we've seen is prime fund balances have gone up sharply in the last at least since lift off. When you look at institutional investors, I think what institutional investors are doing is they're buying bills, right, They're looking at bill yields and saying bill yields are significantly higher than what I can get on a money market fund, right, And so I'm going to buy bills rather than invest in money market fund because I can earn higher yews. What I do not think is true is that I do not believe that multiple years of quantitative easing have somehow suppressed interest rate sensitivity among investors so that they no longer care about four percent yields in money market funds and it will be happy to earn twenty three basis points in a bank deposit and not move I suspect. And we are seeing this as money is coming out of deposits, but it's migrating into higher yielding stuff and not necessarily governmental in money market funds at least for now. Okay, Joe, that was a fantastic explanation of how this all works. Thank you so much for coming on all lots. You fulfilled a long held dream of mine to get you on the show. So thank you so much. All right, thank you. By now, so, Joe, I thought that was not just an interesting walk through the question at hand, which is why aren't banks raising deposit rates? But also kind of a really nice overview of how the monetary policy interaction with the financial system has actually changed since the two thousand and eight financial crisis. No, I mean I was like really interesting, like that sort of headline question, why why don't they raise rates? But also like I was just sort of curious, like how do banks work? You know, like what is seriously like what is the role of deposits? No, now you're like, why isn't more money flowing into government money market funds? Well? Yeah, I mean seriously, but I mean all these things like over time, like the policy changes that were made, you know, post grant, post grade financial crisis that sort of put this premium on deposits. You know, there's this stat that I have seen and heard that like you're more likely to get divorced than to ever change banks in your life. Yeah, and so what I've heard, and I don't know if it's true. Other you know who knows is our frequent guest Patrick McKenzie has written about this. But why do banks still have these physical Yeah? Because if they could just I've heard that if they could just get like a few people in the door you're worth so much money over the course of the lifetime as a customer, even though no one goes into those retail things. And it's partly because no one never really switched at banks. I think it is like a phenomenally sticky business model. And I remember when I went to university in London. I remember banks pitching these student programs, and if I was still in London, I think I would still be with the bank that like recruited me when I was a college student. It's weird because I think, like intuitively, you'd think with the Internet that look that moving money from one of to another would be more liquid, yeah, more easy, But somehow it seems like the opposite, because you have all these apps and you have passwords, and you have bills connected to your account, and so I feel like I'm going to change your banks, Like that's so many things to switch, it's just not worth it. The network effect, Yeah, the same thing that dollar dominance and Twitter dominance and Facebook dominance. Even though it's all it's it's network effects all the way down. So the two other things I thought were really interesting, just very quickly, are that idea of reserve scarcity, and this is something that came up with Bill Nelson when we were talking about why have we seen this tick up in discount lending to the banks. This idea that even though we still have a lot of reserves and liquidity in the system, they are not evenly distributed. Yeah. And then secondly this idea that as quantitative tightening really kicks into gear, you might start to get this process where deposit rates start going higher and there is that substitution effect. Yeah, and the fact that like you can't actually or you're the you're only gonna go get so far taking a crude measure of cash to total assets. Because of this very difference and model between the big domestic banks and the small banks and how they make the smaller banks might run into liquidity scarcity a lot faster than the larger banks. So you know, can see why analysts like Joe are in demand because it's not as simple as just sort of like looking at one number and dividing by another number. Totally, banking is not a monolith. Also, everyone should go deposit rate shopping in order to aimate more money and improve the monetary policy mechanism worse inflation. Will all be getting more income and more income, the last thing that we all need right now. If I had, if I was a fintech, you guys are, and I'd be spending that money. Okay, we're back to the circular nature of like prices going down and then increasing prices, and then we never get out of it. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Past. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe Why isn't thall? You could follow me on Twitter at the Stalwart, follow our producers Kerman Rodriguez at Kerman Ermine and Dash Bennett at dashbot, and check out all of our podcasts here at Bloomberg into the handle at podcasts, and for more Odd Lots content, go to Bloomberg dot com slash odd Lots, where we blog, we post transcripts. We have a weekly newsletter comes out every Friday. Go there and sign up. Thanks for listening.

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