Negative interest rates and the signalling channel

While negative interest rates stimulate the real economy by enhancing credit supply and improving the wealth situation of firms and households, they might come with side effects with regard to banking and financial stability. In an assessment of the trade-off between the ability of a central bank to use negative policy rates to signal lower future deposits rates, against the potential costs on bank profitability, we find that the signalling effect dominates. Thus, a negative interest rate policy is an effective monetary policy tool, even when deposit rates are bound by zero. This document was provided by Policy Department A at the request of the Economic and Monetary Affairs Committee. ` Negative Interest Rates and the Signalling Channel Monetary Dialogue September 2018 This document was requested by the European Parliament's Committee on Economic and Monetary Affairs. AUTHORS Kerstin BERNOTH, Hertie School of Governance, DIW Berlin Alexander HAAS, DIW Berlin ADMINISTRATOR RESPONSIBLE Dario PATERNOSTER EDITORIAL ASSISTANT Janetta CUJKOVA LINGUISTIC VERSIONS Original: EN ABOUT THE EDITOR Policy departments provide in-house and external expertise to support EP committees and other parliamentary bodies in shaping legislation and exercising democratic scrutiny over EU internal policies. To contact the Policy Department or to subscribe for updates, please write to: Policy Department for Economic, Scientific and Quality of Life Policies European Parliament B-1047 Brussels Email: Poldep-Economy-Science@ep.europa.eu Manuscript completed in September 2018 © European Union, 2018 This document is available on the internet at: http://www.europarl. europa.eu/committees/en/econ/monetary-dialogue.html DISCLAIMER AND COPYRIGHT The opinions expressed in this document are the sole responsibility of the authors and do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorised, provided the source is acknowledged and the European Parliament is given prior notice and sent a copy. Negative Interest Rates and the Signalling Channel PE 626.070 3 CONTENTS LIST OF ABBREVIATIONS 4 LIST OF BOXES 5 LIST OF FIGURES 5 EXECUTIVE SUMMARY 6 INTRODUCTION 7 CLASSIC MONETARY POLICY TRANSMISSION 10 FINANCIAL STABILITY CONCERNS 13 WEIGHING THE COSTS AND BENEFITS 15 4.1. On the effectiveness of negative interest rates 15 4.2. Negative interest rates and bank profitability 17 4.3. On the optimality of negative interest rates 18 CLOSING REMARKS 20 REFERENCES 21 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies 4 PE 626.070 LIST OF ABBREVIATIONS APP Expanded Asset Purchase Programme ECB European Central Bank EONIA Euro OverNight Index Average LIBOR London Interbank Offered Rate DFR Deposit Facility Rate NFC Non-financial Corporation RD Nominal Deposit Rate RR Nominal Reserve Rate SMP Securities Market Programme ZLB Zero lower bound Negative Interest Rates and the Signalling Channel PE 626.070 5 LIST OF BOXES Box 1: Why do banks hold excess reserves? 9 LIST OF FIGURES Figure 1: ECB deposit facility rate and EONIA negative 7 Figure 2: Euro area household deposit rates bound by zero 7 Figure 3: Euro area bank net interest margins in decline 8 Figure 4: Liquidity in the euro area banking system on the rise 8 Figure 5: Stylized bank balance sheet 10 Figure 6: Crisis scenario with different monetary policy responses 16 Figure 7: Output decomposition in response to a negative rates shock 17 Figure 8: Bank profitability in response to a negative rates shock 18 Figure 9: Optimal policy under discretion and commitment 19 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies 6 PE 626.070 EXECUTIVE SUMMARY • Confronted with below target inflation, sluggish growth, and increasing financial market uncertainty, on June 5, 2014, the ECB’s Governing Council decided to decrease its deposit facility rate into negative territory. Since then, it has pursued a negative interest rate policy. • Due to a zero lower bound constraint on returns to retail deposits, this policy has created a wedge between reserve and deposit rates in the euro area. Despite this, banks hold record levels of excess liquidity. This can be attributed to demand as well as supply factors. • The banking system plays an important role for the transmission of monetary policy to the real economy. Our analysis suggests that negative interest rates have a significant impact on this transmission by changing the relative importance of the classic transmission channels. • While in aggregate, negative interest rates seem to stimulate the real economy by enhancing credit supply and improving the wealth situation of firms and households, they might come with side effects with regard to financial stability. • Our analysis of the impact of negative interest rates on financial stability yields the following results for the euro area: (i) empirical evidence suggests only a limited amount of additional risktaking by banks; (ii) private sector inefficiencies due to the large provision of liquidity cannot be ruled out, even though there is no consensus on their quantitative extent; (iii) so far, there is little empirical evidence for excessive cash hoarding; and (iv) there is only very limited empirical evidence for adverse effects of the ECB’s negative rate policy on bank profitability. • To quantitatively weigh the costs and benefits of the ECB’s negative interest rate policy, we use a macroeconomic model by de Groot and Haas (2018). In this model, a novel signalling channel of negative interest rates complements the classic transmission channels, highlighting one additional benefit of negative rates: Even with classic monetary policy transmission constrained by the zero lower bound on deposit rates, a cut of the policy rate into negative territory can be expansionary as the central bank signals that it will hold deposit rates lower for longer, which lowers interest rate expectations and stimulates economic activity. • In an assessment of the trade-off between the ability of a central bank to use negative policy rates to signal lower future deposits rates, against the potential costs on bank profitability, we find that the signalling effect dominates. In this modelling framework, a negative interest rate policy is an effective monetary policy tool, even when deposit rates are bound by zero. • A negative interest rate policy stimulates bank net worth. Significant capital gains and a more favourable economic environment, that induces banks to increase credit supply to the real economy, outweigh the costs of negative rates. A simple welfare analysis yields that under reasonable conditions, negative interest rates might constitute an optimal crisis response. • We conclude that the ECB’s negative interest rate policy has most likely been an effective monetary policy tool and a complement to its rate forward guidance policy. • An effective banking regulation and an alert banking supervision are crucial to ensure that the benefits of the ECB’s current negative interest rate policy continue to outweigh its costs. Negative Interest Rates and the Signalling Channel PE 626.070 7 INTRODUCTION Since the 2007/08 financial crisis and the subsequent Great Recession, negative nominal interest rates have become an additional policy tool for central banks in many developed countries. Confronted with below target inflation, sluggish growth, and increasing financial market uncertainty, on June 5, 2014, the Governing Council of the European Central Bank (ECB) decided to decrease the deposit facility rate (DFR), the interest rate banks receive for holding overnight deposits at the central bank, to -0.10%. The DFR was further lowered in increments of 10 basis points to its current level of -0.40% on March 16, 2016. As expected in times of excess reserves in the banking system, the Euro OverNight Index Average (EONIA), an interbank market measure that states the rate at which banks accept deposits from and provide loans to each other, has traced the behaviour of the DFR closely (Figure 1). Figure 1: ECB deposit facility rate and EONIA negative Source: ECB Statistical Data Warehouse. Figure 2: Euro area household deposit rates bound by zero Source: de Groot and Haas (2018). Eisenschmidt and Smets (2018) provide a similar overview for euro area NFC deposit rates. 1 Compared to other central banks that adopted a negative rate policy, both the ECB’s phase-in of negative rates as well as its eventual level are not exceptional: In Switzerland, the Swiss National Bank set its target range for the 3-month LIBOR CHF at -0.75% to 0.25% in December 2014, and lowered this range to -1.25% to -0.25% in January 2015. In Sweden, the Riksbank set its deposit rate to -0.5% in July 2014. In February 2015, it set its deposit rate and repo rate to 0.85% and -0.1%, respectively. In February 2016, the deposit rate and repo rate reached their lowest point of -1.25% and -0.5%, respectively. In Denmark, the Danmarks Nationalbank set its certificates of deposit rate at -0.05% in September 2014, reaching its lowest point of -0.75% in February 2015 (de Groot and Haas, 2018). -1 0 1 2 3 4 5 2006 2007 2008 2009 201