When central banks raise interest rates to fight inflation, the familiar demand-side story of what happens is simple: households postpone consumption, aggregate demand falls and inflation comes under downward pressure.
The supply side, however, is less straightforward. If firms borrow to finance their operating costs, a monetary tightening can raise marginal costs, putting upward pressure on inflation – a mechanism that economists refer to as the cost channel of monetary policy.
But the cost channel still misses an important part of firms’ balance sheets: firms not only borrow; they also hold large amounts of cash in bank deposits. My research shows that these deposits affect how monetary policy is transmitted to inflation and real economic activity.
In the framework I propose, firms finance their operating costs with a combination of borrowing and previously accumulated deposits. Debt can be attractive because interest payments are tax-deductible, while market power in the banking sector implies low returns on deposits.
A borrowing constraint gives deposits additional value because they provide liquidity when external finance is limited. This creates an important interaction between debt and liquid balances.
The key point in my study is that deposits and debt must be analysed together.
The overlooked mechanism: the deposit spread and the cost channel
A key concept is the corporate deposit spread: the difference between the policy rate set by the central bank and the interest rate that firms receive on their deposits.
In recent years, that spread has been large and persistent. During the latest cycle of monetary tightening, it stayed at around 300 basis points (three percentage points) for more than a year in both the euro area and the United States. This means that even while policy rates were rising sharply, firms were still earning relatively little on the liquid funds that they kept in the banking system.
This matters because firms use deposits to manage operations, not just to save passively. When deposit rates do not keep up with policy rates, firms forgo income on the balances on which they rely, effectively raising the cost of running the business.
I uncover what I call a deposit-side cost channel of monetary policy. A tightening affects firms not only through borrowing costs: it also changes the return on the liquid balances that they hold for operational purposes. That weakens labour demand, changes inflation dynamics and alters the output effects of monetary policy.
Firms’ balance sheets matter: the net debt revaluation channel
I also highlight a channel driven by the interaction between debt and liquid balances, which becomes especially important during monetary tightening. When inflation falls, firms’ net nominal position changes in real terms. For firms that are net debtors, this worsens their financial position and tightens the financial constraints that they face.
This deterioration reduces the funds available to cover wage bills, which in turn lowers labour demand, output and consumption. In other words, monetary tightening also works through firms’ financial structure.
Together with the deposit spread, this forms what I refer to as the net debt revaluation channel.
The mechanism does not rely on sticky prices. Even in a flexible-price setting, monetary policy is not neutral: changes in inflation can affect real economic activity because they change the real value of firms’ outstanding nominal positions. This underlines the importance of firms’ liquidity management for monetary policy transmission.
What the data show
The argument is motivated by several empirical facts:
- First, the corporate deposit spread widens when central banks’ policy rates increase.
- Second, firms hold large liquid balances and also carry substantial debt. In US firm-level data, liquid holdings amount to roughly 18-25% of assets, while debt is about 27-28% of assets.
- Third, firms are net debtors on average, which means that debt exceeds liquid holdings for the typical firm.
These facts suggest that deposits and debt should be analysed together rather than treated as simple opposites.
My research also provides micro-level evidence. I calculate firms’ exposure to local deposit rates by combining regulatory bank filings, branch deposit shares and data on firms’ balance sheets, assigning exposure based on the location of firms’ headquarters.
I then study how differences in deposit spreads interact with monetary policy surprises. The results suggest that firms that face higher deposit spreads reduce their wage expenditure more when policy tightens.
After a monetary tightening of 100 basis points (one percentage point), a firm whose deposit spread is one percentage point higher experiences a cumulative fall in real wage expenditure of about 5% over two years, relative to an otherwise similar firm with a lower spread.
A different view of recent tightening cycles
To study the broader macroeconomic effects, I compare the baseline economy with a counterfactual benchmark in which deposit markets are perfectly competitive, meaning that the spread is zero. Both economies are fed the same estimated shocks, so that the comparison isolates the effect of imperfect deposit competition.
The results suggest that the spread has been far from negligible.
During the interest rate hiking cycle of 2022-24, the elevated spread implied a policy rate about 50-150 basis points higher relative to that benchmark. It also added roughly 120-200 basis points to cumulative inflation. The associated cumulative output loss was around 1-2% in the euro area and the United States. The effects were also large in the run-up to the global financial crisis.
Policy implications: looking beyond lending rates and banking competition
The policy message is clear. To understand the full effects of interest rate decisions, central banks need to look beyond lending rates. Weak pass-through to deposit rates creates an additional transmission channel: it raises the value of liquidity and tightens financial constraints, shaping firms’ decisions.
This offers a new perspective on why inflation may respond less sharply to monetary tightening: by raising firms’ effective operating costs, the deposit spread pushes against the usual disinflationary effect of higher policy rates.
More broadly, the structure of deposit markets matters for macroeconomic outcomes. In economies where banks have greater market power, the same policy tightening may affect inflation and output differently than in more competitive markets. Corporate deposit rates are not just a side detail of banking: they are part of the transmission of monetary policy itself.
