The Broader View: The Positive Effects of Negative Nominal Interest Rates

IMF Blog, April 10, 2016

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The Broader View: The Positive Effects of Negative Nominal Interest Rates

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Bibliographic details

• Authors: Jose-Vinals, Simon Gray, Kelly Eckhold
• Published: April 10, 2016

Key findings and overall assessment

• The authors "support the introduction of negative policy rates by some central banks" given significant risks to growth and inflation.
• Experience is limited, but the tentative conclusion is that negative nominal rates "help deliver additional monetary stimulus and easier financial conditions, which support demand and price stability."
• There are limits on "how far and for how long negative policy rates can go," and negative rates should be one element of a broader policy mix including structural reforms, growth-friendly fiscal policies, and prudential policies.

Why central banks are using negative policy rates

• Negative nominal policy interest rates are an addition to unconventional monetary policy tools available once policy rates hit the "zero lower bound."
• Six central banks so far have introduced negative rates that apply to some amount of the cash balances commercial banks hold with the central bank.
• Policy objectives:
  • Encourage the private sector to spend more.
  • Support price stability by further easing monetary and financial conditions.
  • For smaller open economies, help discourage capital inflows and reduce exchange rate appreciation pressures.
• Synergies with quantitative easing:
  • Negative rates have been associated with expanded central bank balance sheets due to quantitative easing or large-scale foreign exchange purchases.
  • Quantitative easing compresses yields and term premia but reduces the availability of assets for further purchases over time.
  • Moving policy rates negative aims to lower money market rates, push down the yield curve further, and boost portfolio substitution effects.
  • "Negative deposit rates tend to have more bite when a large amount of commercial banks’ reserves are priced at the negative rate."

What is new about negative nominal rates

• Negative real rates have existed when inflation exceeded nominal interest rates; negative nominal interest rates are new.
• When nominal rates become negative, transmission mechanisms may differ due to "non-linearities associated with the downward stickiness of retail deposit rates."
• Retail deposit rates are "unlikely to fall below zero" because depositors could switch to cash to avoid negative rates.

Transmission channels and the experience so far

• Main transmission channels: portfolio rebalancing, bank lending, and exchange rate.
• Portfolio balance channel:
  • Wholesale interest rates have fallen with central bank deposit rates.
  • Money market trading activities appeared to have declined, though it is unclear if this reflects negative rates or surplus liquidity from quantitative easing.
  • Lower risk-free wholesale rates encouraged investors to switch to riskier assets (equities, corporate bonds, property).
  • Lower wholesale rates reduced funding costs for borrowers that finance directly in commercial paper and corporate bond markets.
• Bank lending channel:
  • Impact differs across banks depending on funding models and lending practices.
  • Wholesale bank funding costs have fallen, but decreases in lending rates have been limited by retail deposits remaining anchored at zero or above.
  • Banks more reliant on customer deposits have been less able to reduce lending rates.
  • In most cases, lending rates have fallen since the introduction of negative policy rates, but there is wider dispersion of experiences; some retail lending rates have even increased.
  • Lending rates fall more where there is a higher proportion of variable rate loans, shorter loan maturities, or high competition among banks—explaining why corporate loan rates have fallen further than retail rates.
  • Credit growth in the euro area, for example, "has picked up since the introduction of negative rates."
• Bank profitability and mitigation:
  • Banks benefit from policies that support price stability and growth through stronger borrower creditworthiness, lower nonperforming loans, reduced provisioning costs, and capital gains on securities.
  • Net interest margins appear to have been squeezed by negative rates plus quantitative easing, but mitigating factors have offset this to some extent.
  • Some banks have raised alternative income via fees or commissions.
  • Many central banks have exempted a portion of commercial bank balances from the negative rate using a "tiering" system.
• Exchange rate effects:
  • Impact has been mixed: portfolio rebalancing has in some cases led to cross-border outflows and exchange rate depreciation.
  • In some cases (for example, Denmark) central bank actions helped reduce capital inflows; elsewhere other factors drove exchange rates.

Limits on the use of negative policy rates

• Limits exist both on the depth (how negative) and the duration (how long) policy rates can remain negative.
• Risk of substitution into cash:
  • Individuals, corporates, and banks could increase use of cash as store of value or settlement medium if rates are expected to be substantially negative and long-lived.
  • Banks could hold vault cash for interbank settlement instead of balances at the central bank.
• Staff ballpark estimates for the tipping point at which moving into cash becomes worthwhile range from minus 75 basis points (bps) to minus 200 bps.
• Costs of using cash:
  • One-off costs: expanding vault capacity, transporting cash to private vaults, setting up systems.
  • These one-off costs would be spread over time; expected duration of negative rates is crucial to the decision.
• Country variation and denomination effects:
  • The tipping point will vary by country and be influenced by the highest denomination banknotes.
  • "The physical space required for storing US$1 million equivalent would be similar in Denmark, Hungary, Japan, and the United States; but lower in the eurozone and Switzerland where there are higher denomination notes (EUR 500 and CHF 1,000)."
  • Evidence exists of increased demand for large value notes in Switzerland.
• Political economy and social constraints:
  • Public perception that depositors are being "taxed" if deposit rates turn negative could weaken support for the policy.

Unintended consequences and risks

• Bank profitability concerns:
  • Banks have been unwilling or unable to pass negative rates onto retail depositors, squeezing net interest margins.
  • For banks unable to generate higher earnings through lending volume or fees, negative rates could pose a significant profitability challenge.
• Spillovers to savers and financial institutions:
  • If policy rates stay negative too long, spillovers to savers could have negative social consequences; similar risks exist with persistent low positive rates.
  • Prolonged low rates could undermine life insurers, pensions, and savings vehicles, making it difficult to meet guaranteed returns and potentially forcing losses on life insurance policy holders due to duration mismatches.
• Risk-taking and financial stability:
  • Squeezed bank margins may lead banks to lend to riskier borrowers or rely more on volatile wholesale funding.
  • Weak loans may become harder to detect and corporate restructuring could be delayed.
  • Negative rates may induce boom and bust cycles in asset prices.
  • These risks require close monitoring, supervisory scrutiny, and possibly stronger prudential responses.

Policy implications and recommendations

• Negative nominal rates can provide additional monetary stimulus and ease financial conditions, helping support demand and price stability.
• However, negative rates have clear limits; monetary policy cannot be the sole tool.
• Recommended complementary measures:
  • Well-designed structural reforms.
  • Growth-friendly and supportive fiscal policies.
  • Prudential policies that enhance the resilience of the financial sector.
• Supervisory and policy authorities should monitor risks from bank profitability pressures, excessive risk-taking, and vulnerabilities in insurance and pension sectors, and be prepared to respond with prudential measures.

Authored by José Viñals, Simon Gray, Kelly Eckhold — April 10, 2016.