A speech by Professor John Iannis Mourmouras, Deputy Governor of the Bank of Greece, examines the impact of low and negative interest rates on economies. He starts by stating that this unconventional monetary policy is not temporary. Rates will be ultra low for a long time. As a result, bank profits will be eroded; financial market will be negatively impacted; investors will be forced to take higher risks so creating stability risks; governments will not be under pressure to reduce debt; and operational risks increase. He concludes that the time has come for other policy tools, including fiscal and structural ones.
After nine years of low interest rates and large-scale market interventions, the consensus is that this unconventional monetary policy is not temporary, while in most advanced economies the prospect for normalisation seems rather remote. Indeed, most of continental Europe (the euro area, Denmark, Sweden and Switzerland) and, as of last January, also Japan have moved towards a much more accommodative monetary policy by introducing negative policy interest rates, and/or negative central bank deposit rates. Together with forward guidance and quantitative easing, such measures have created an unprecedented situation, in which nominal interest rates are negative in a number of European countries across a range of maturities in the benchmark yield curve, from overnight to even five- or ten year maturities! Indeed, 88 of the 346 securities in the Bloomberg Eurozone Sovereign Bond Index have negative yields, thus nearly $2 trillion of debt issued by European governments is currently trading at negative yields. Illustrative examples are those of Switzerland and Germany, in which 18 out of 19 bond issues and 14 out of 18 bond issues respectively are priced with negative yields. As a result, almost one quarter of the world’s GDP is produced in countries with negative interest rates.
There are, however, a number of concerns associated with the use of negative interest rates, each of which is considered in turn.
I. Erosion of bank profitability: As negative deposit rates impose a cost on banks with excess reserves, there is a higher probability that the banks’ net interest margins (the gap between commercial banks’ lending and deposit rates) will shrink, since 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 also fall. The central bank could reduce concerns about bank profitability by raising the threshold at which the negative central bank deposit rate applies, as the Bank of Japan recently introduced a three-tier system, a different way from the ECB’s negative interest rate policy. Doing so, however, it could reduce the transmission of negative deposit rates to market rates, namely the power of negative interest rate policy transmission through the credit and portfolio rebalancing channel. Moreover, compressed long-term interest rates also reduce profit margins on the standard banking maturity transformation of short-term borrowing and lending at a somewhat longer term. So far, lenders have been reluctant to pass on the costs of negative rates to customers and have taken almost all of the burden. But, as recent research by the BIS
shows, the impact on profitability becomes more drastic over time, as short-term benefits such as lower rates of loan defaults diminish.II. 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 rates in the market are negative for a considerable period of time, prompting large outflows and closures and reducing liquidity in a key segment of the financial system. For insurance and pension funds, a low-for-long interest rate environment poses challenges, which may even be exacerbated if rates enter into negative territory. They may find themselves unable to meet fixed long-term obligations. Life insurance companies will also be less able to meet guaranteed returns.
III. Excessive risk-taking: Increased financial stability risks, stemming from search for yield and higher leverage. Keeping interest rates at negative levels for a long time increases borrowing attractiveness in key sectors of the economy and the risk of bubbles. This can not only lead to an inefficient allocation of capital, but leave certain investors with more risk than they appreciate, as investors in search of higher yields necessarily turn to excessive risky assets.
IV. Disincentive for government debt reduction: With interest rates at negative levels, governments are under no pressure to reduce their debt. Negative rates actually encourage them to borrow more. And if government borrowing becomes a sort of free lunch, there is a clear disincentive for fiscal discipline. Ultra-low interest rates flatter the debt service ratio, painting a misleading picture of debt sustainability. For instance, persistent negative rates may potentially act as an “anaesthetic” to governments of eurozone countries, especially in the europeriphery, meaning that they will proceed only slowly with fiscal and structural reforms, given the fiscal space that they gain from lower debt servicing costs.
V. Operational risks: The issuance of interest-bearing securities at negative yields may face design challenges. Areas that are commonly mentioned as sources of concern are interest bearing securities, particularly floating-rate notes (renegotiating, collecting interest, use as collateral) in the context of negative interest rates. More generally, if negative rates were to prevail for long, they may entail the need to redesign debt securities, certain operations of financial institutions, the recalculation of payment of interest among financial agents, and other operational innovations, the costs of which may offset negative rate benefits. For instance, most option-pricing models either do not work or do not work well with negative interest rates, particularly entailing risks for the compatibility of trading systems and other market infrastructure.
In brief, persistent negative rates may change expectations and create distortions (for instance, in terms of saving habits and, in that sense, they may be a topic for behavioural economists to look at). It is still unknown what their long-term effects will be (e.g. on the erosion of bank profitability). In contrast, QE has been tested successfully in the US and the UK and I would also like to remind you that monetary policy– conventional or unconventional – entails considerable time lags. It takes time to see the results at full length. However, there is definitely something positive about negative interest rates: it is a strong reminder that the time has come for other policy tools, including fiscal and structural ones.
