Benoît Coeuré: Life below zero - learning about negative interest rates
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the annual dinner of the ECB's Money Market Contact Group, Frankfurt am Main,
9 September 2014.
* * *
Accompanying slides can be found here: http://www.ecb.europa.eu/press/key/date/2014/html/sp140909.en.pdf
I would like to thank Florian Heider for his contribution to this presentation. All opinions expressed remain mine.
Ladies and Gentlemen (Slide 1),
It is a pleasure to be here with you tonight. The Money Market Contact Group plays a key
role in informing the ECB's decision making process. As a tribute to your collective foresight,
I would like to recall that in your meeting on 25 June 2012, you were among the first to
discuss the operational consequences of lowering the ECB's Deposit Facility Rate (DFR) to
zero or below zero. This will be the topic of my remarks tonight.1
A few months ago, on 5 June, the ECB lowered the main refinancing rate to 0.15%, the
marginal lending rate to 0.40%, and - maybe most noteworthy - the Deposit Facility Rate to
minus 0.10%. Last week, on 4 September, these rates were cut to 0.05%, 0.30% and -
0.20% respectively, and it was stated that the lower bound had now been reached. The ECB
also decided in June to remunerate current account balances in excess of the minimum
reserve requirements at the deposit facility rate as opposed to zero as was the case
previously. With these measures, we entered practically uncharted territory.
When Gregory Mankiw in 2009 stated in the New York Times that "it may be time [...] to go
negative", he revived an idea that may seem odd at first. If lowering interest rates stimulates
the economy and policy rates are already very low or even zero, then why not keep cutting
rates and have negative interest rates? The idea of negative rates, that is, lending 100 and
getting back say 95, may seem absurd "but remember this: Early mathematicians thought the
idea of a negative number was absurd [too]".2
In fact, the idea of negative interest rates, or "taxing money", goes back to the late nineteenth
century, to Silvio Gesell, the German founder of "Freiwirtschaft". The historic academic
opinion on Gesell is divided. Irving Fisher supported him and John Maynard Keynes called
him "a strange, unduly neglected prophet", others a "typical monetary crank".3
So where do we stand in the euro area? I would like to answer this question today by
addressing the following points:
• What does it mean to have one of our policy rates, the deposit facility rate, below
zero?
• Why did we go negative?
• What are in principle the benefits and costs of such a move?
And, with the benefit of some hindsight since June, what is the initial assessment?
•
To begin with, it is important to point out that the deposit facility rate has a specific, narrow
meaning: under a negative DFR, banks that have more funds in their account with the ECB
than what they need to fulfil their reserve requirement lose some money. Suppose, for
instance, that a bank has €100 million of excess reserves continuously for one year, then at
an interest rate of -0.20% it receives back € 99.8 million, so the cost of depositing funds with
the ECB for a full year is € 200,000.
Why do banks accept such a cost of depositing excess reserves with the central bank? The
answer is that the alternatives to depositing excess reserves are also costly. In fact, the cost
of using alternatives to central bank deposits determines to what extent the rate on excess
reserves can go negative in practice.
Banks can always choose to hold physical currency instead of electronic money in their
accounts with the ECB. Since physical currency has a zero nominal rate of return, there is
what I would call an "economic lower bound" for the rate on excess reserves. It is difficult to
identify but it is not zero because the effective rate of return on currency is negative. One
does not even need to impose a demurrage rate or regular stamping on banknotes, as Irving
Fischer has proposed based on Gesell's ideas.4 There is a cost of storing, holding, and more
importantly, using physical currency.5 This involves the cost of renting, maintaining and
securing storage facilities such as vaults as well as the cost of shipping currency around in a
safe and timely manner. A recent ECB study estimated the private cost of cash payments to
be 1.1% of GDP on average in the participating countries.6 The unit social cost was
estimated at 2.3 cents per euro of transaction. This is substantially higher than the unit social
cost of a credit transfer or other non-cash means of payments per euro of transaction.
Because the overnight unsecured money market alone currently involves hundreds of banks
with an aggregate transaction volume of around € 40-50 billion every day, replicating this
scale of transacting with physical money would be a formidable and costly task, both
privately and socially.
I would not go as far as Kenneth Rogoff and conclude that having only electronic money, by
pushing down the economic lower bound, would recreate room for manoeuvre for central
banks in a protractedly low inflation environment.7 The ECB is committed to bringing euro
area inflation back at a level below but close to 2%, in line with its mandate.
But what is then the rationale for a negative rate on the deposit facility? Why impose a cost
on banks' excess reserves?
One should view the negative rate in the context of the ECB's aim to provide further
monetary policy accommodation inter alia by lowering policy rates without impairing market
intermediation.8 There are a number of reasons why it is desirable to keep a certain distance
4
Stamping of banknotes was famously tried in the city of Wörgl, Austria, in 1932. Bills were introduced with a
devaluation rate of 1% per month unless holders would buy stamps to extend their nominal value. See
Champ, B., 2008. Stamp script: Money people paid to use. Economic Commentary, Federal Reserve Bank of
Cleveland, April.
5
Beyond the direct opportunity cost, moving the deposit rate into deeply negative territory may involve indirect
costs, depending on the ability of banks to pass it to their customers, in particular retail ones.
6
Schmiedel, H., Kostova, G., and W. Ruttenberg, 2012. "The social and private costs of retail payment
instruments. A European perspective", ECB Occasional Papers Series , No. 137.
7
Rogoff, K., 2014, "Costs and benefits to phasing out paper currency", NBER Working Paper 20126
8
For an early explicit analysis of this rationale in a New-Keynesian model, see Buiter, W. and N. Panigirtzoglou,
2003, "Overcoming the zero bound on nominal interest rates with negative interest on currency: Gesell's
solution", The Economic Journal, 113, 723-746.
between the main refinancing and the deposit rates. The relative difference between the cost
of borrowing from the ECB and the benefit of depositing with the ECB determines the
incentive to lend in the interbank market. Having an active interbank market is important to
obtain price signals about the transmission of policy rates into the economy. It is also
important to reduce bank excessive reliance on central bank money, which has been a key
factor of resilience in the post-crisis environment.
In the words of Michael Woodford, "the demand for [overnight funds] is a function of the
location of the overnight rate relative to the lending rate and the deposit rate, but
independent of the absolute level of any of these interest rates."9
To see the role of the relative difference, consider the following thought experiment. For the
sake of the argument, let me abstract from credit risk in the overnight market and assume
that there is enough eligible collateral to borrow from the ECB. Hence, there would be no
material difference between very short-term secured and unsecured borrowing and lending.
Banks with excess reserves would only lend in the interbank market at a rate that is above
the deposit rate. Banks with a shortage of reserves would only borrow in the interbank
market at a rate that is below the main refinancing rate. Suppose now the main refinancing
rate is equal to the deposit rate. Then there is no rate at which trade is possible. Hence, it is
important to keep a spread between the main refinancing and the deposit rate in order to
support market activity.
Another benefit of lowering the deposit rate together with the main refinancing rate is that in
the current situation with excess liquidity, short-term interest rates such as EONIA track the
deposit rate more closely than the main refinancing rate.10 The banking system as a whole
has excess liquidity, which currently stands at around € 130 billion. When the excess liquidity
increases, rates fall since less must be borrowed in the interbank market (the demand curve
shifts down). In order to make sure that the monetary policy accommodation is passed on to
the interbank market under fixed-rate full allotment and excess liquidity, it is therefore not
enough to lower just the main refinancing rate. In fact, the deposit rate may be the most
important policy rate of a central bank in an environment of excess liquidity.
The decision to lower rates, which was accompanied by a number of other measures to
stimulate credit to the economy such as "targeted" long-term operations (to induce banks to
lend more to the real sector) and an announcement of purchases of asset-backed securities
and covered bonds based on claims on the euro area real economy, is also fully in line with
the ECB's forward guidance. Forward guidance implies that interest rates remain at present
or lower levels for an extended period of time conditional on an assessment of the economic
outlook.
Following the June decision, the lower policy rates were transmitted well to the money
market and, in line with forward guidance, market uncertainty about the expected path of
policy rates fell. EONIA forwards curves flattened and shifted down (Slide 2). In addition, the
volatility of EONIA rates as well as the option-implied volatility of short-term interest rates
dropped. The lower policy rates were also transmitted to longer maturities and to market
segments other than the unsecured money market. EURIBOR rates and rates implied by
EURIBOR futures fell after the June decision and again after the September decision (Slide 3
and 4). Unsecured money market interest rates are now negative for a maturity of up two
weeks. Besides, the General Collateral (GC) pooling repo curve as well as yields on euro
area Treasury bills and notes have further adjusted.
The EONIA has regularly been set in negative territory since 28 August together with stable
trading volumes (the average daily EONIA volume from January to June 2014 was
€ 26.1 billion and was € 28.9 billion since June) (Slide 5) and homogenous transmission to
closely substitutable market segments, such as GC pooling repo, are evidence that a large
fraction of unsecured money market transactions can take place at negative rates without
hampering market functioning. This reflects an effective and well-coordinated preparation of
market participants since the ECB first mentioned the possibility of bringing the DFR below
zero.
The fact that money market trading volumes did not fall (they actually rose) is remarkable
given the fears some observers had expressed, informed by the Japanese experience of the
1990s, on the potential impact on market functioning of a negative DFR and of very low
policy rates more generally.
Will the transmission of lower short-term rates to a lower cost of credit for the real economy
be as smooth? While bank lending rates have come down in the past in line with lower policy
rates, there is a limit to how cheap bank lending can be. The mark-up that banks add to the
cost of obtaining funding from the central bank compensates for credit risk, term premia and
the cost of originating, screening and monitoring loans. The need for such compensation
does not necessarily fall when policy rates are lowered. If anything, a central bank lowers
rates when the economy needs stimulus, which is precisely when it is difficult for banks to
find good loan making opportunities. It remains to be seen whether and to what extent the
recent monetary policy accommodation translates into cheaper bank lending.11
Another concern with lowering rates is that it may contribute to the instability of the financial
sector. While this can be a valid concern, in practice, a causal chain is difficult to establish.
Do low rates really lead to instability (e.g., though an excess search for yield) or are rates low
because there has been instability in the financial system and the economy is in need of
stimulus?12 That said, reducing excessive risk aversion in financial markets has been a
welcome (side) effect of central bank policies during the crisis. The question is whether
risk-taking in the financial sector has now already gone too far, contributing to growing
financial imbalances, frothy asset price valuations and too loose credit standards.
Irrespective of the answer to this question, given the low inflation environment, it is clear that
monetary policy cannot currently assume the role of addressing such concerns for the euro
area. It is therefore the task of macro-prudential policies to deal with potential financial
imbalances. The supervisory set-up in Europe has undergone significant improvements that
will help to ensure the soundness of the financial system. As we enter an extended period of
low interest rates, we must stand ready to use to their full extent the new macro-prudential
instruments that the national competent authorities and the ECB are now entrusted with.
An important aspect of lowering policy rates was that it also reaffirmed our forward guidance
and helped to clarify the ECB's commitment to ensure that the monetary policy stance
remains appropriate to the needs of the euro area economy. This is reflected in the
EONIAOIS curve being now flat and in negative territory for a maturity of up to three years,
reflecting market expectations of negative EONIA fixings well into 2017 (Slide 6), and in a
widening gap between the expected path of US and euro area interest rates. (Slide 7).
A negative deposit rate can, however, also have adverse consequences. For a start, it
imposes a cost on banks with excess reserves and could therefore reduce their profitability.
Note, however, that this applies to any reduction of the deposit rate and not just to those that
make the rate negative. For sure, lower bank profitability could hamper economic recovery,
especially in times when banks have to deleverage owning to stricter regulation and
enhanced market scrutiny. But whether bank profitability really falls when policy rates are
lowered depends more generally on the slope of the yield curve (as banks' funding costs
may also fall), on banks' investment policies (as there is scope for them to diversify their
cash investment both along the curve and across the credit universe) and on factors driving
non-interest income.13 More fundamentally, banks are profitable in a healthy economy where
households and companies strive to finance their projects, which is what our accommodative
monetary policy aims to achieve in the first place.
In fact, both ensuring a smooth transmission of our low policy rates to the cost of credit to the
economy and supporting the profitability of banks will ultimately depend on whether
economic policies at the euro area and at the country level are successful in putting euro
area economies back on a path of strong and stable growth, by mobilising both supply-side
and, where available, demand-side instruments. A prudent, well-capitalised banking system
is needed in any case, and the ECB's Comprehensive Assessment together with the start of
the Single Supervisory Mechanism are key in this respect.
In order to avoid the cost of excess reserves, banks may also, decide to borrow less from the
ECB. This would reduce excess liquidity in the banking system and put upward pressure on
interest rates in the interbank and bond market, which could counteract the reduction of
policy rates. But this is not what we have seen so far.
Despite the discussion on the adverse consequences of a negative deposit rate, there was
no significant impact on the functioning of money markets. I already mentioned the smooth
transmission of rates and the stable trading volume in EONIA. Similarly, the level of excess
liquidity or the amount of deposits with the ECB (Slide 8) has been largely unaffected.
However, one possible reason for the stable level of the money market function could be the
declining, but still existing fragmentation of the money markets. While a lot has been
achieved, for example TARGET2 imbalances have fallen by nearly half since their peak in
mid-2012 (at € 572bn on 3 September, € 541bn below their peak level reached in July 2012),
market fragmentation in the euro area is still present.14
If banks with excess reserves are predominately highly profitable banks located in
non-stressed countries, then a potential adverse effect on bank profitability may be less of a
concern from the financial stability perspective. Similarly, if banks have good reason to
borrow from the ECB, for instance when other sources of funding are not available, and if
those banks that borrow are not necessarily the same as those that deposit with the ECB,
then excess liquidity in the banking system may not fall.
What about the impact of negative rates on market fragmentation in the euro area? Evidence
from actual money market transactions shows that fragmentation still significantly hampers
the smooth transmission of lower rates across the euro area. Banks located in non-stressed
countries can now borrow in the overnight unsecured market at negative rates. Rates for
borrowers located in stressed countries are mostly positive and the distribution of rates is
wide, ranging from slightly negative to slightly above the main refinancing rate.
That said, there is some evidence that lower rates have reduced fragmentation in secured
markets. The search for yield in the low rate environment has increased the demand for
higher yielding, but still safe products such as repo or sovereign bonds, including those of
non-core countries.15 The higher demand has pushed down and thus compressed interest
rates in secured markets.
Let me conclude. Given the theoretical arguments for and against lowering some policy rates
into negative territory, and given the practical experience so far, what is the verdict? Or,
coming back to the opinions on Gesell: should he be considered a prophet or monetary
crank?
While the final verdict is certainly still out, based on the presented evidence so far, it seems
fair to say that the lowering of policy rates, with the deposit rate moving into negative
territory, has provided an appropriate monetary policy stimulus to the euro area economy,
comforted the forward guidance of the ECB, and contributed to some reduction in market
fragmentation, without having an adverse impact on the functioning of money markets.
As the money market settles in negative territory, and other market segments start
experiencing negative yields, we now have to make sure that the broader market community
is prepared to cope with this new environment.
Thank you for your attention.