SPEECH
BY GOVERNOR LARS ROHDE
AT THE NATIONAL ASSET-LIABILITY
MANAGEMENT EUROPE
CHECK AGAINST DELIVERY
1 March 2018
INTEREST RATES - LOW FOR LONG
Thank you very much for the opportunity to speak here today. It is my
great pleasure to be able to share with you some of Denmark's experi-
ences with low interest rates, as well as my views on future issues in
monetary policy.
Exceptionally easy monetary policy has played a fundamental role in
supporting the economic recovery over the past decade. Now, a con-
tinued and more robust global upswing is expected to be accompanied
by normalisation of interest rates. This development is welcome and has
been a long time coming. But the withdrawal from monetary stimulus will
also reveal whether vulnerabilities have accumulated in some parts of the
financial sector. Further, it will show just how robust our economies are
to higher financing costs.
In the following, I will focus on three key messages:
First, I will talk about global growth. My main point here is that while the
long-awaited global upturn is gaining strength, growth is not likely to
attain pre-crisis levels.
Second, I will discuss the effects of low rates and unconventional mon-
etary policy. Central bank balance sheets have expanded substantially. In
Denmark, banks' earnings have been under pressure, although the im-
pact on overall profitability has been limited.
And finally, the pace and timing of policy normalisation will require care-
ful calibration. International spillovers from major central banks are inev-
itable, especially for small open economies. The final implementation of
regulatory reforms and an effective macroprudential policy framework
will be essential to containing financial stability risks.
1. Long-awaited global upturn gains strength, but pre-crisis growth rates
are likely unattainable
Slide 2: Global economy is strengthening
After a long period of disappointing outturns, global growth is strength-
ening. Forecasts are now being revised up. Stronger and more broad-
based global growth and increasing trade are being supported by pri-
vate consumption and higher investments. Indicators of consumer and
manufacturing sentiment point towards a continued cyclical upswing in
the coming years.
Although it may be tempting, policymakers cannot spend time compla-
cently enjoying the long-awaited recovery. One reason is that the cyclical
upswing is exactly that ... cyclical. Continued higher growth in the me-
dium-term is not a given and potential growth is still deemed lower than
pre-crisis levels in many countries. The mantra from international institu-
tions has changed accordingly. Previously, we were reminded not to
waste a good crisis. Now, we should not waste a good recovery. Imple-
mentation of structural reforms and rebuilding of fiscal buffers are crucial
for sustaining growth and preparing for the next downturn. This is espe-
cially true, given that monetary policy has been pushed to its limit. Thus,
monetary policy cannot be relied upon to provide much further stimulus,
should the cycle turn sooner than expected.
As regards structural reforms, progress has been mixed. In Denmark, we
are currently reaping the benefits of past reforms to increase the struc-
tural supply of labor. This is contributing to a more balanced upswing,
compared to the boom and associated overheating in the mid-2000s. So,
while structural initiatives are unlikely to affect cyclical outcomes in the
short-term, I certainly agree that they are important for a sustained re-
covery.
Slide 3: Lower growth rates to be expected going forward
But we also have to consider whether we can realistically expect growth
rates in advanced countries at pre-crisis levels again. This is unlikely, due
to demographic change, among other things. A recent study by Dan-
marks Nationalbank points to a reduction in GDP per capita by about 0.3
percentage points until 2050, due to the ageing population. Obviously,
this should not be an excuse. Continued steps to increase productivity
and enhance flexibility in labor markets are important. However, it would
seem prudent to set our expectations for future growth realistically, and
adjust fiscal forecasts accordingly.
2. Low rates and unconventional monetary policies have supported the
economy
Slide 4: Danish monetary-policy rates are closely linked to ECB rates
It has now been ten years since the global financial crisis disrupted the
global economy. Looking back today, it has been a very exciting decade
- too exciting perhaps - from a central banking perspective.
High public debt levels restrained the fiscal capacity in a number of coun-
tries following the financial and economic meltdown. Thus, central banks
were more or less left on their own to support economic activity. Conse-
quently, very low and even negative policy rates have become common
globally, alongside massive expansions of some central bank balance
sheets.
Danmarks Nationalbank was a central bank pioneer when we first cut our
deposit rate below zero already in 2012. This was done to offset large
capital inflows. As you might already know, the fixed exchange rate policy
in Denmark means that our monetary policy rates are exclusively re-
served for maintaining the peg against the euro. Therefore, the key mon-
etary policy rate of Danmarks Nationalbank tends to track that of the ECB
very closely.
In Denmark, we have had negative rates for some years now. So far, their
implications have been far less exciting or radical than some might have
expected before entering negative territory. Basically, negative interest
rates have just been a continuation of low rates, with strong pass-
through to money market rates. However, the financial sector has had to
adapt to the new environment.
Negative interest rates have put pressure on banks' earnings
Slide 5: Households are exempt from negative deposit rates
First of all, negative rates have challenged Danish banks' business
models. Net interest margins and thereby net interest income have been
squeezed. The introduction of negative policy rates has meant that a sig-
nificant share of bank deposits with Danmarks Nationalbank is currently
being remunerated at a rate of -0.65 per cent. While lending rates have
mirrored the fall in monetary policy rates, banks have been reluctant to
introduce negative deposit rates on household deposits. This likely re-
flects concerns about reputational risks. In contrast, negative rates have
been more widely introduced on corporate deposits.
The spread between short term and long term interest rates is also im-
portant for banks' maturity transformation business. The ECB's large
scale asset purchases have worked to reduce the spread between long
term and short term interest rates. This has made such efforts less profit-
able for banks.
These declining margins have lowered banks' net interest income signifi-
cantly. The largest banks have so far been able to compensate by ex-
panding into new business areas, such as wealth management, and by
adjusting their fees. Smaller banks typically rely more heavily on deposit
funding. For them, the adjustment has been much more difficult.
On the positive side, negative interest rates have contributed to a fa-
vourable macroeconomic climate driving loan impairment charges to a
minimum. The effect from very low impairment charges is one of the main
explanations for the record-high results booked by the largest Danish
banks in recent years. These results have been achieved despite the pres-
sure from falling interest margins.
Increased resilience of banks should lower the expected return on equity
Slide 6: More resilience and low interest rate: Required return on bank
equity can be lowered
With the strengthening of profits in recent years, Danish banks have
clearly put the financial crisis behind them. Equally important, we now
have a financial sector that is much more robust than prior to the crisis.
The financial crisis revealed that many financial institutions were insuffi-
ciently capitalised. As a result, some of them were not resilient to the
losses incurred in the wake of the crisis and the subsequent market cor-
rection. This inability to absorb losses exacerbated the economic down-
turn. Since then, much has been done to increase the resilience of the fi-
nancial system, both internationally and in Denmark. For example, capital
requirements have been enhanced, and the solvency of Danish financial
institutions has improved considerably. This has contributed to a more
robust financial system as a whole.
Expected returns are likely to be lower than pre-crisis levels as an effect
of higher capitalisation and increased resilience of banks. Especially in a
low interest rate environment, the perception that returns on equity
should be double-digit is misguided. And setting targeted returns at such
high levels may trigger banks to take on far too much risk and create new
vulnerabilities for the future. It may take some time for investors to adjust
their expectations. They will need to take into account that the risks em-
bedded in banks' shares have declined with increased capitalisation and
that banks have become a safer investment.
Central bank balance sheets have expanded markedly
Slide 7: Expanding central bank balance sheets
With interest rates closer to their effective lower bound than ever before,
central banks have had to resort to new approaches to achieve the ne-
cessary monetary accommodation. These approaches include unconven-
tional measures such as targeted lending operations, asset purchases
and forward guidance.
Consequently, several central banks in advanced economies have experi-
enced pronounced balance sheet expansions. This is clear evidence that
monetary policy has played a key role during the last decade of crisis
management in the global economy.
Usually, variations in the balance sheet of Danmarks Nationalbank reflect
changes in our foreign-exchange reserves. And as you probably know,
Denmark experienced a massive inflow of currency shortly after the Swiss
central bank's decision to abandon the floor on the Swiss franc against
the euro. Over the following weeks, we saw unusual turbulence in the
Danish foreign-exchange market. So in response, we used our usual
measures to defend the peg. We intervened heavily in the FX market by
buying euros and selling Danish kroner to meet the elevated demand. In
addition, monetary policy rates were significantly reduced. The sizeable
intervention caused a sharp increase in FX reserves by almost 15 per cent
of GDP in less than two months. As the pressure abated, the level of FX
reserves was gradually reversed over the course of 2015 to reach a level
of just above 20 per cent of GDP - close to the current level.
We do not have a specific target for the foreign exchange reserves, but it
should remain sufficient to support the peg. For example, due to financial
turmoil in 2008, Danmarks Nationalbank decided to increase the size of
its foreign-exchange reserves in order to signal its commitment to the
fixed-exchange-rate policy.
Rising asset valuations in light of easy financial conditions
Let me now move on to the effects of exceptionally supportive monetary
policy on financial markets. In the current environment of easy financial
conditions, asset valuations and leverage have risen. Asset price in-
creases may reflect improved macroeconomic prospects, but also a
search for yield. This has compressed spreads on high-yield debt and re-
duced risk premia.
Slide 8: Rising house prices in European cities
In Denmark, we are especially focused on risks associated with house
price developments. A number of European countries experienced hous-
ing bubbles in the years prior to the financial crisis, including Denmark. In
the post-crisis period of low rates, real estate prices have again increased
rapidly in many countries - from China to Canada to Australia and the
Nordics.
In most countries, real house prices in and around larger cities have risen
most. To some extent, this reflects various structural factors, such as ur-
banisation, rising incomes, and supply constraints in some cities. But this
could also be an indication of financial recklessness. In Denmark, we are
thus paying close attention to house prices in Copenhagen. These prices
are beginning to bear some resemblance to levels reached during the
bubble in the mid-2000s. However, when taking account of fundamental
factors, such as mortgage rates, income levels, and the housing stock,
there is no clear sign of a speculative bubble - at least not yet.
In general, house prices should be assessed relative to income levels.
This chart shows house prices in several large European cities, relative to
GDP per capita. Here, Copenhagen is not currently an outlier. Elevated
price levels are a wide-spread issue in European cities, and we have re-
cently seen corrections in Stockholm and Oslo. Price developments
should be carefully monitored and appropriately addressed pre-
emptively through, for example, macroprudential measures. In Denmark,
we have taken steps, requiring higher financial robustness for buyers in
major cities. For sure, housing affordability is also a major social issue to
be tackled, but this is largely beyond the remit of central bankers.
3. Normalisation of monetary policy entails risks
Timing of normalisation requires careful calibration
Now, I would like to turn the perspective towards the future. It is evident
that we still have a whole range of challenges we need to address.
Going forward, a key stability challenge for central banks will be to man-
age a balanced exit strategy from easy monetary policy. As output gaps
close and unemployment decreases in both the US and the euro area,
normalisation is expected to proceed gradually. Synchronisation with
economic developments will be critical. Missteps are likely to be followed
by abrupt asset price adjustments and financial market disruption. Op-
positely, if the normalisation phase is excessively prolonged, build-up of
vulnerabilities in the financial system may be exacerbated. Either way,
normalisation entails risks. Steady and well-communicated policy tighten-
ing will be important to manage market expectations.
In this regard, it will be important to follow developments in government
bond markets. The recent correction in equity markets was accompanied
by a surge in implied volatility. The increase in implied volatility on long-
term German government bonds over the same period was modest, and
it remains well below its average level over the past ten years.
Finally, normalisation of monetary policy could be complicated by con-
tinued subdued inflation. Recent higher inflation in the euro area seems
to be mainly driven by energy prices, while core inflation remains low.
The possible flattening of the Phillips curve has received a lot of attention
lately. In Denmark, nominal wage growth has remained modest, despite
capacity pressures and increasing labour shortages in some sectors.
However, real wage growth has been above the historical average since
the beginning of 2015.
International spillovers from major central banks are inevitable, especially
for small open economies
As the Federal Reserve and the ECB initiate balance sheet normalisation
and rate hikes, the effects will be transmitted to other economies be-
cause of the high integration of global financial markets. This is not news
to you. Both stability and turbulence in financial markets are increasingly
synchronised across regions and continents. This is so, even as monetary
policy cycles and economic recoveries differ in timing. International spill-
overs of balance sheet normalisation are thus inevitable and not to be
underestimated, if past experience is any guide.
Obviously, the Danish exchange-rate peg can only be maintained be-
cause we are willing to implement the same monetary policy stance as
the euro area. This is a precondition in a world with international capital
mobility. A strong spillover from the ECB's monetary policy to Danish fi-
nancial conditions is therefore to be expected.
A recent study1 from Danmarks Nationalbank shows how the ECB's asset-
purchase programme had a clear spillover effect on Danish bond mar-
kets. Since the beginning of the ECB's QE-programme, the reaction of
Danish sovereign bonds has been very much in line with German bonds.
This is the case even though no official bond purchases took place in
Denmark. Therefore, we should also be prepared for the opposite effect
when the ECB starts to roll back its unconventional measures.
In general, small open economies are highly influenced by global mon-
etary policy factors. And it has been confirmed by leading researchers
that this applies for countries with fixed as well as floating exchange
rates. Therefore, you might say that small open economies to a large de-
gree import the financial conditions set by larger economies.
Spillovers are best mitigated through robust economic policies. Here, it is
important for countries to live up to the so-called OHIO principle, keep-
ing their own houses in order. Furthermore, continued international co-
operation will be crucial. I would like to conclude my intervention here
today with some more detailed comments regarding a specific area
where cross-border harmonisation is vital, namely financial regulation.
New regulatory framework is essential for financial stability
Slide 9: A new foundation of financial regulation
Solid capital adequacy is an important component of the new post-crisis
regulatory framework. This framework is still in the implementation
phase, internationally and in Denmark. In my view, the regulatory frame-
work, which in the EU is based on the single rulebook, rests on three pil-
lars. These pillars address capital, liquidity and resolution. As already
emphasised, this means first, ensuring a solid, true and fair capital ad-
equacy position based on the actual risk exposure of banks. Second, we
need requirements to ensure healthy liquidity management and stable
financing, as included in recent Basel reforms. Last but not least, we need
a credible resolution regime. In the European case, we need strict imple-
mentation of the EU directive on Banking Recovery and Resolution. This
includes setting minimum requirements for own funds and eligible liabil-
ities to be used in the resolution of a bank in troubles. It also includes
formulating credible resolution plans for credit institutions. This is all
about getting the incentives right. No credit institution should be "too
big to fail".
These are well-known areas of progress since the crisis, but we still have
some way to go before the new and harmonised regulatory framework is
fully in place. There are indeed still bumps on the road. At the current
juncture, where the memory of the last financial crisis seems to be fading,
it is important that we stay committed to the implementation of the new
regulation. This will reduce the likelihood of a new financial crisis with all
its detrimental effects on our economy.
If we - through ongoing reforms and implementation of the new rules
being adopted in Basel and Brussels - end up delivering on all three pil-
lars of regulation, then I think we have learned our lesson from the crisis
well. And once all these measures are in place, we will be ready to take
the next step: removing unnecessary red tape by simplifying the remain-
ing part of the regulation and easing some of the administrative burden
on banks.
The three-pillar system would leave it to market forces to keep the finan-
cial sector in check. As long as banks perform on all three parameters,
the credibility and soundness of their balance sheets and business
models will ensure their access to necessary capital and funding. And
with the resolution regime in place, we no longer need governments to
save banks with taxpayers' money.
Conclusion
To conclude, this period of low interest rates and unconventional mon-
etary policy has been fundamental for the economic recovery. While
global economic developments are indeed strengthening, we should be
prepared for lower growth rates going forward. Structural reforms to lift
potential growth and rebuilding of fiscal buffers are important.
Low interest rates have also left a legacy, affecting banks' earnings, cen-
tral bank balance sheets, as well as asset-price valuations. As normalisa-
tion of monetary policy proceeds, we must be ready to carefully manage
risks and spillovers. Implementation of regulatory reforms and an effect-
ive macroprudential framework will be essential to contain financial sta-
bility risks.
Thank you very much for your attention.
DANMARKS
NATIONALBANK
NATIONAL ASSET-LIABILITY MANAGEMENT EUROPE
CONFERENCE
​1 March, 2018
Global economy is strengthening
​Positive output gaps in the US and euro area
​Upward revisions to economic forecasts
Per cent of potential GDP
Real GDP growth , per cent year-on-year
4
4
Projection
3
2
3
Output gap closed
1
0
2
US
-1
-2
1
-3
Euro area
-4
2016 2016 2016 2016
2017 2018 2017 2018 2017 2018 2017 2018
-5
0
Euro area
05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 World UK
US
IMF projections Jan 2018 IMF projections Oct 2017
Lower growth rates to be expected going forward
​Demographic headwinds to future GDP growth
Percentage of people aged 70+ relative to 20-69
60
50
40
30
20
10
0
Denmark Sweden Italy USA Japan
2000 2025 (projection) 2050 (projection)
Danish monetary-policy rates
are closely linked to ECB rates
Per cent
6
Danmarks Nationalbank
5
4
3
2
ECB
1
0
-1
-2
Households are exempt from negative deposit rates
Per cent per annum
2,0
1,5
1,0
Deposits, households
0,5
Deposits, corporates
0,0
Certificates of deposits
-0,5
-1,0
More resilience and low interest rate:
Required return on bank equity can be lowered
Equity and required return
Required return, per cent
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14
Market-based equity ratio, per cent
Expanding central bank balance sheets
Per cent of GDP Per cent of GDP
40 40
ECB
35 35
30 30
Fed
25 25
20 20
15 15
10 10
5 5
0 0
Rising house prices in European cities
​Price per square meter, residential flats, per cent of nominal GDP per capita
Per cent
16
14
12
10
8
6
4
2
0
Paris Amsterdam Oslo Stockholm Berlin Vienna Copenhagen
A new foundation of financial regulation