Much has happened in central banking since the financial crisis. We live in an era of very low, in many cases, negative nominal interest rates. We now know the mysterious lower-bound rate in monetary policy – some call it ‘the twilight of interest rates’ – is below zero.
After nine years of low interest rates and large-scale market intervention through quantitative easing, the prospect for normalisation of unconventional monetary policy seems somewhat remote. Some analysts view the new ‘QE with a negative interest rate’ as a regime shift from quantitative targeting to interest rate targeting, considering negative rates to be the new ‘global norm’. Indeed, most of continental Europe (the euro area, Denmark, Sweden and Switzerland, and from January also Japan, have introduced negative policy interest rates and/or negative central bank deposit rates. On 13 March the European Central Bank reduced its policy rate further, to minus 0.4% from minus 0.3%.
Nominal interest rates are negative in several European countries across a range from overnight to five- or 10-year maturities. Nearly $2tn of debt issued by European governments is trading at negative yields.
Shifting interest rates to negative territory reduces borrowing costs for firms and households, boosting demand for loans and incentivising investment and consumer spending. This affects the economic outlook and bolsters confidence. These changes in turn influence investment and saving decisions of firms and households, and should raise demand for domestically produced goods and services. With capital inflows discouraged, downward pressure on the exchange rate will increase, supporting external demand.
There are also effects with regard to holding cash, which involves storage, insurance, handling and transportation fees. This cost is what defines the effective lower bound. Once policy rates fall too far into the negative zone, below the costs of holding cash, people will start to hoard money instead of holding negative-yielding deposits. In such cases, cash will be held by people as a store of value, indistinguishable from bonds. Banks will be left with fewer deposits and the economy with fewer loans.
The underlying question is how far and for how long negative rates can go. There are a number of concerns. Negative deposit rates impose a cost on banks with excess reserves, so there is enhanced probability that the banks’ net interest margins (the gap between commercial banks’ lending and deposit rates) will shrink. Banks may be unwilling to pass negative deposit rates onto their customers to avoid an erosion of their customer base and subsequent reduced profitability.
The extent of the decline in profitability will depend on the degree to which banks’ funding costs fall too. So far, lenders have been reluctant to pass on the costs of negative rates to customers, and have borne themselves almost all of the burden. Bank for International Settlements research shows that the impact on profitability becomes more drastic over time as short-term benefits, such as lower rates of loan defaults, diminish.
There are also negative effects on financial markets. Money market funds make conservative investments in cash-equivalent assets, such as highly rated short-term corporate or government debt, to provide liquidity to investors and help them preserve capital by paying a modest positive return. While these funds aim to avoid reductions in net asset values, this objective may not be attainable if market rates are negative for a considerable period, prompting large outflows and closures and reducing liquidity in a key segment of the financial system. ‘Low for long’ interest rates, and particularly negative ones, make it harder for insurance companies and pension funds to meet fixed long-term obligations and fulfil guaranteed returns.
An additional problem is that, with interest rates at negative levels, governments are under no pressure to reduce their debt. Negative rates encourage them to borrow more: a disincentive for fiscal discipline. Ultra-low interest rates flatter the debt service ratio, painting a misleading picture of debt sustainability. Persistent negative rates may act as an anaesthetic to euro area governments, especially in the periphery. The fiscal space gained from lower debt service costs may slow enactment of necessary fiscal and structural reforms.
The long-term effects of negative interest rates are unknown, as they may change expectations and create distortions, for example, in saving habits. While QE has been tested successfully in the US and the UK, with negative interest rates, monetary policy is sailing into uncharted waters. Yet negative rates encompass one inherently positive aspect: they deliver a strong reminder that the time has come to use other policy tools to boost demand, including fiscal and structural ones.
Prof. John (Iannis) Mourmouras is Deputy Governor, Bank of Greece, and a former Deputy Finance Minister. This is an abridged version of a speech at the ‘Asset and risk management seminar for public sector investors’ organised by the Lee Kuan Yew School of Public Policy, National University of Singapore, and OMFIF on 29 March 2016 in Singapore.