Megan Greene and Eric Lonergan on Dual Interest Rates and the Prospects of Average Inflation Targeting

Episode Summary

Executive Summary: Megan Greene and Eric Lonergan argue central banks still have substantial room to stimulate economies, especially through dual interest rates that separate lending incentives from reserve remuneration. They contend this tool can bypass the effective lower bound, support demand, and avoid harming savers, while acknowledging political, legal, and communication challenges versus conventional monetary policy.

Main Topics: Dual interest rates as a new monetary tool (Priority: 5/5): The guests explain how a central bank can set a lending/funding rate separately from the rate paid on reserves, allowing it to stimulate borrowing without forcing down returns to savers. Why central banks are not out of ammunition (Priority: 5/5): They push back against claims that the Fed and others have exhausted policy options, arguing QE, yield curve control, negative rates, and especially targeted funding still leave room for action. ECB TLTROs as the model (Priority: 5/5): The discussion centers on the ECB’s targeted longer-term refinancing operations as the practical prototype for dual rates, where cheap funding is conditional on new lending. Critiques: arbitrage, misallocation, and balance-sheet risk (Priority: 4/5): They address concerns that banks will game the system, capital will be misallocated, or central bank equity will be impaired, arguing these risks are manageable and not unique to this tool. Monetary vs. fiscal policy blur (Priority: 4/5): The guests argue the line between monetary and fiscal policy is not clean in practice; central banks already make distributional choices and are increasingly in politically sensitive territory. Average inflation targeting and credibility (Priority: 3/5): The conversation closes by assessing the Fed’s new framework, with both speakers saying it is directionally positive but likely hard to explain, implement, or make credible without stronger tools.

Key Arguments: Central banks still have room to respond because policy rates in many jurisdictions remain above zero, and even where they do not, targeted lending programs can substitute for broad rate cuts. Dual interest rates let central banks stimulate borrowers while protecting savers by keeping reserve remuneration higher than the lending/funding rate. Targeted funding tools can be better than blunt negative rates because they can channel credit toward desired sectors and reduce some asset-price distortions. Arbitrage concerns are overstated: regulated banks face supervisory constraints, and reserve creation is ultimately controlled by the central bank, not individual banks. Central bank balance-sheet losses are not a unique or decisive objection; the real constraint is inflation and loss of control over money, not accounting equity. The distinction between fiscal and monetary policy is blurry in practice, but dual-rate lending is still best understood as monetary policy because it changes the price and quantity of base-money-linked funding. Average inflation targeting may lack credibility if inflation has persistently undershot target and the Fed cannot generate enough overshoot with conventional tools. Communication is a major obstacle: explaining average inflation targeting or dual-rate schemes to the public and politicians is harder than explaining a single rate. A tiered reserve framework could complement dual rates by allowing central banks to manage reserve quantities and money-market rates more flexibly. Fiscal policy is preferred in a first-best world, but in the real world of political constraints, dual interest rates offer a practical backstop when deflationary pressures intensify.

Data Points: ECB TLTRO rate example: as low as -4% - Used as an illustrative recommendation for how aggressively the ECB could lower targeted lending rates to stimulate demand. Current U.S. interest on reserves: 0.10% - Referenced when translating the dual-rate idea into a Fed example using the discount window versus reserve remuneration. Fed discount rate example: minus 2% to minus 3% - Illustrative hypothetical range suggested for how the Fed could set a lending rate below reserve remuneration. Inflation undershoot since 2012: just under 1.5% average inflation - Megan Greene cites this as evidence that the Fed may struggle to credibly overshoot 2% under average inflation targeting. Fed inflation target: 2% - The benchmark used to discuss average inflation targeting and whether the Fed can make up for past shortfalls. Take-up of TLTRO: significant and widespread - Megan notes Christine Lagarde said ECB uptake was broad and had a major effect. Policy horizon example: 5-year negative 4% loans - Eric uses this as an example of how dual rates could supercharge green or infrastructure investment.

Pivotal Quotes: "Dual Interest Rates Give Central Banks Limitless Firepower" — Hosts/article title: The core thesis of the episode and the authors’ recent VoxEU piece. "you can actually benefit both savers and borrowers at the same time" — Megan Greene: Explaining the main advantage of separating the lending rate from reserve remuneration. "The point here is, you set an independent interest rate on required reserves and excess reserves." — Eric Lonergan: Describing how tiered reserves can support the dual-rate framework and improve central bank control.

Implications: If adopted, dual rates could give central banks a more targeted, politically palatable way to fight deflation and support lending without crushing savers. The broader debate suggests future monetary policy may become more differentiated, sector-specific, and less reliant on one blunt policy rate.