The ECB's Negative Rate Policy Has Been Effective but Faces Limits
IMF Blog, August 10, 2016
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- The ECB's Negative Rate Policy Has Been Effective but Faces Limits
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- Authors: Huidan Lin, Andreas Andy Jobst
- Published: August 10, 2016
Background and Rationale
- More than two years ago the ECB began charging interest on excess liquidity that banks held at the central bank as part of easing measures aimed at bringing inflation back to the ECB’s price stability objective of "below, but close to, two percent over the medium term."
- Rationale: charging (rather than remunerating) deposits at the ECB should encourage commercial banks to lend more to consumers and companies, boosting consumption, investment, and economic growth, and preventing inflation from sinking too low—or becoming negative.
Historical constraint and policy innovation
- For a long time many economists and policymakers believed central banks could not cut the policy rate below zero because commercial banks would charge customers for deposits and households and firms would withdraw cash (reference to Bech and Malkhozov, 2016).
- Negative nominal policy rates allow further reduction in real interest rates (nominal rates minus inflation) when inflation is too low and the natural rate of interest is below prevailing real rates.
Track record of negative interest rates (after two years)
- IMF staff assessment: "so far, it has been successful."
- Observed effects:
- Eased financial conditions and reduced the cost of borrowing for both banks and their customers (ECB, 2016; Heider and others, 2016).
- Lower funding costs for banks have strengthened the ECB’s "forward guidance."
- Lower borrowing rates for households and firms contributed to a modest credit expansion—favorable to growth and inflation.
- Deposit rate cuts helped amplify the impact of asset purchases by encouraging banks to reduce cash balances and invest in riskier, higher-yielding assets.
Unique challenges in the euro area
- The ECB charges interest only on excess liquidity, so the charge is greater in countries where banks hold large excess reserves—generally those with substantial current account surpluses within the monetary union.
- Banks’ interest revenues per euro of assets have suffered because reliance on a wide deposit base has prevented them from cutting what they pay for customer deposits as much as what they charge for loans.
- In several large economies, loans are typically indexed to the policy rate ("variable rate loans"), so banks face reduced margins on both new lending and existing loans (as discussed in the IMF’s April issue of the GFSR).
How banks have mitigated profitability pressures
- Measures banks have used to offset margin pressures include:
- Higher lending volumes
- Lower interest expenses
- Capital gains from investments
- Lower risk provisioning
- Small increases in fees and commissions
- Savings from cost cutting (Rostagno and others, 2016)
- IMF assessment: "there are clearly limits to such mitigation measures."
Diminishing returns and policy trade-offs
- The ECB has limited room for further substantial rate cuts without hurting bank profitability.
- Prolonged low policy rates have clouded the earnings outlook for most banks, suggesting benefits from a negative interest rate policy "might diminish over time," while future lending growth may be insufficient to offset declining interest margins in some countries.
- Further policy rate cuts could create a trade-off between effective monetary transmission and bank profitability:
- Lower bank profitability and equity prices could pressure banks with slender capital buffers to reduce lending, especially those with high levels of troubled loans.
- If lending rates fail to adjust or customers withdraw cash, additional rate cuts could weaken the effectiveness of monetary policy.
Policy implications and recommendations
- Given diminishing returns to deeper negative rates, the ECB may need to rely more on purchases of assets.
- Rationale for focusing on asset purchases:
- Raise asset prices and aggregate demand
- Support bank lending
- Facilitate the pass-through of improved bank funding conditions to the real economy
- Caution: additional rate cuts risk hurting bank profitability and could be less effective if banking-sector responses undermine transmission.
IMF Blog post by Huidan Lin and Andreas (Andy) Jobst, August 10, 2016.
Content in this bundle
- How have central banks implemented negative policy rates?
- Country Report
- The euro area bank lending survey - First quarter of 2016
- Full Report
- Country Report
