Why Savers Might Miss Out on the Benefits of Higher Interest Rates

A lot of retirees love the prospect of the US Federal Reserve raising interest rates. With higher rates, there is less of a need to go beyond the risk curve to achieve a desired nominal return bogey, since a simple savings account should offer higher deposit interest rates.

But do higher interest rates actually lead to higher returns on savings?

According to new research from the Stern School of Business at New York University, for every 1% increase in interest rates, the rate banks pay on a typical savings deposit rises by just 0.34%. So even a 2% increase in rates would translate into a relatively paltry 0.68% bump in what consumers would receive from the bank. Not exactly a silver bullet for retirement planning.

Why do savers fail to capture the benefits of higher interest rates? This question requires an investigation into how monetary policy affects banks’ fortunes. Textbooks talk a lot about reserve requirements — the amount of funds a bank must hold against client bank deposits. It’s a nice story, but in this day and age, only a tiny fraction of bank liabilities require holding reserves.

The Fed pays interest on reserves and will continue to do so after “liftoff” — when the Fed raises interest rates to more normal levels. Late last year, the Fed raised rates for the first time in almost a decade. But in subsequent meetings, it hit the pause button, leaving its key interest rate unchanged. Many have interpreted this as a retreat from a previous forecast for four .25% rate hikes in 2016. Fed funds futures now indicate a 21% chance of additional tightening this year.

Can banks benefit from such muted increases? Conventional wisdom would say, “Not by much.” But this line of reasoning may be flawed.

Itamar Drechsler, Alexi Savov, and Philipp Schnabl point to a different answer in their recent paper, “The Deposits Channel of Monetary Policy.” They begin by highlighting that with every 1% increase in interest rates, the rate banks pay on a typical savings deposit rises by just 0.34%. That’s a 0.66% spread that banks can earn without breaking a sweat — not a bad business model!

But this juicy spread comes at a cost to households with assets held as bank deposits. The paper states, “As deposits become more expensive, households reduce their deposit holdings and replace them with imperfect substitutes.” In this way, consumers are disadvantaged by being forced into taking incremental risk to achieve market returns. Deposits on domestic chartered banks are about $10 trillion, so this is a big change in spreads on a very big base.

The authors maintain that the banks’ market power over retail deposits drives this effect. When interest rates are low, banks do not make much money from deposits because investors can easily switch to holding cash. But when rates are high and cash becomes expensive to hold, banks can get away with charging more in the form of bigger deposit spreads. Like any monopolist, they restrict supply to maximize profits, and as they do, deposits flow out of the banking system.

To make their case, Dreschsler and company contend that when the Fed raises rates, the spread banks charge on deposits increases, and deposits flow out in more concentrated markets where banks don’t have to compete with each other. This is true even for branches of the same bank located in different parts of the country. Deposit spreads in concentrated markets go up more within a week of a Fed rate hike, even when the rate hike is fully expected. In other words, it really is the Fed that drives deposit supply through banks’ market power.

What does this tell us about what to expect?

1. Banks with a lot of retail deposits stand to make a lot more money after liftoff. If you’re a stock picker, look for banks with branches in noncompetitive places, like some of the regional banks in the Midwest.
2. To maximize profits, banks are likely to contract their balance sheets, making credit tighter.
3. From a personal standpoint, it might be a good time to think about moving your money to a money market fund or an internet bank. Of course, as others do the same, you can expect Treasury bills and other safe liquid assets to become more expensive, impacting liquidity in financial markets more broadly.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

You can read more from Wes Gray at the Alpha Architect blog. Please read the Alpha Architect Disclosures at your convenience.

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