NEGATIVE RATES: A TWO-SIDED COIN
Why are negative nominal interest rates so troubling? Economic theory favors real rates, which have already been negative in most developed countries for some time. In theory, lowering the nominal policy rate into negative territory should produce many of the same expansionary effects as cutting the policy rate in a positive rate environment: to make individuals and companies save less and spend and invest more. Lower real rates should also lead to a depreciating currency, which improves a country's external competitiveness, and supports asset prices, boosting the wealth of the private sector.
In practice, though, negative interest rates come with three key drawbacks:
- They impair the banking system. As the policy rate turns more negative, banks start earning less return on their assets, while the interest they pay on deposits generally stays above zero - due to relatively high competition for deposits, legal challenges, political resistance and the potential for cash withdrawals. As profits decline, banks may issue fewer loans to businesses and households, or raise the interest rate they charge for those loans. Lower bank equity prices risk exacerbating these effects.¹
- They create significant challenges for other parts of the financial system. This includes the pension and insurance sectors, which offer nominal return and minimum income guarantees in the future, but that are hard to deliver when interest rates are negative, as they don't generate enough yield.
- Negative nominal rates may lead to more, not less, savings. Economists refer to this concept as "money illusion," as what should matter - at least if people were completely rational - are not nominal but rather real, or inflation-adjusted, variables. While "money illusion" may hold for rate cuts in a positive rate environment too, the effects are likely magnified under the zero line.
WHAT'S THE EVIDENCE SO FAR?
We studied the effect of negative rates in five different countries, drawing some conclusions on their effect on financial markets, bank deposits, lending rates and volumes, and macro variables, such as growth and inflation. Our universe includes: Denmark (which first brought the policy rate into negative territory in July 2012), Eurozone (June 2014), Switzerland (December 2014), Sweden (February 2015) and Japan (January 2016). We found that:
- The policy has been successful in easing financial market conditions so far. Negative policy rates (figure 1) have led to a fall in both short-term and long-term market rates, with 2-year and 10-year government bond yields on average declining roughly as much as policy rates (figure 2). However, the policy looks to have had mixed impact on countries' currencies: while the euro and Swedish krona underperformed, the yen and the Swiss franc appreciated (figure 3). The policy also had a positive impact on risk assets, with stock prices on average rising, although this result is skewed by a significant rise in Denmark. Importantly, bank equity prices have suffered in the negative rate environment, challenging the sustainability of any improvements in financial conditions.
- The impact on bank lending conditions appears to have been positive. On balance, banks have lowered household and corporate deposit rates, though by less than the policy rate, while lowering lending rates roughly as much as the policy rate. On average, financial institutions have increased the pace of loan creation (figure 4), especially in the Eurozone, albeit from a low starting level.
- The macro impact seems to have been positive, but modest. While the policy has been associated with stronger growth (figure 5), the dispersion of outcomes has been high. On the other hand, the policy appears to have been unsuccessful in lifting inflation (figure 6) and inflation expectations. In this regard, we note the European Central Bank's (ECB) analysis that negative rate policy has had the least impact on growth and inflation relative to the other easing measures it has implemented recently.