Speech
Embargo
24 October 2016, 6.15 pm
Monetary policy using negative interest rates: a status report
Vereinigung Basler Ökonomen
Thomas Jordan
Chairman of the Governing Board∗
Swiss National Bank
Basel, 24 October 2016
© Swiss National Bank, Zurich, 2016 (speech given in German)
Ladies and gentlemen
In January 2015, the Swiss National Bank discontinued the minimum interest rate against the
euro, and at the same time lowered the interest rate on banks' sight deposits held at the SNB
to -0.75%. Today - almost two years later - not only short-term interest rates, but yields on
10-year and even longer-dated Confederation bonds, are negative. Some corporate bonds in
Swiss francs are now also negative yielding.
Many people consider negative interest rates to be unnatural. Paying interest on credit
balances seems to violate the logic and laws of economics. Savers worry about their capital,
banks about their profitability and pension funds about meeting their obligations. There are
also doubts about whether the SNB's negative interest rate policy is having the desired effect.
Negative interest rates are certainly unusual. They are uncharted territory and represent a
major challenge for many players in the economy, particularly investors.
The SNB takes these concerns very seriously. In my speech today, I would like to explain our
negative interest rate policy. I will start by clarifying that there are two reasons for the low or
even negative interest rates in many countries. First, the global equilibrium interest rate has
fallen over recent decades. Second, since the financial crisis, monetary policy worldwide has
been expansionary as a result of low inflation and weak economic recovery.
For Switzerland, a country with generally low interest rates, these two factors - a long-term
decline in the equilibrium interest rate and expansionary monetary policies around the world -
have made the negative interest rate necessary in order to ensure appropriate monetary
conditions. As a small open economy, we cannot decouple ourselves from a global
environment of low interest rates.
In the second part of my speech I will look at whether the negative interest rate policy is
fundamentally effective. As this status report will show, the laws of economics do not change
significantly when interest rates turn negative. As far as the mechanism of monetary policy is
concerned, there is therefore no reason why the policy rate should not be reduced below the
zero lower bound in the case of a country like Switzerland. On the contrary: without negative
interest rates, the Swiss franc would have appreciated even more strongly, growth would have
collapsed, accompanied by even lower inflation, and unemployment would have risen.
Nevertheless, phases of low or negative interest rates also present monetary policy challenges
and have economic side-effects, which must not be ignored and which I would like to address
in the third part of my speech. I will stress that expansionary monetary policy is no panacea
for growth in advanced economies. Only structural reforms and adjustments in the real
economy can create the conditions for a sustained recovery - and thus for a normalisation of
monetary policy. Expansionary monetary policy can make these necessary adjustments easier,
but it cannot replace them and must not delay them.
Before talking about the mechanism of negative interest rates in Switzerland, I would first like
to examine the international environment and explain why global interest rates today are so
low.
Low rates as a global phenomenon
The current very low interest rate level is the result of a global secular trend. Interest rates
have not just been declining since the outbreak of the financial crisis, they have been falling
steadily in recent decades. Chart 1 shows that nominal yields on government bonds with a
remaining maturity of ten years in Switzerland, Germany and the US are more than 6
percentage points lower today than they were back in 1990.
Nominal interest rates are currently at a record low worldwide. But it is important to
distinguish between nominal interest rates and real interest rates, which are ultimately relevant
for most economic decisions. I should perhaps mention here for the sake of completeness that,
put simply, real interest rates are nominal interest rates less inflation.1 Chart 2 shows
longterm real interest rates in Switzerland, Germany and the US, calculated as the difference
between the nominal yield on 10-year government bonds and the observed inflation rate. I
should emphasise two points: First, while real interest rates in Switzerland are currently
negative, a historical comparison shows that this is by no means a new phenomenon. For
example, real interest rates in Switzerland were also negative in the 1990s. Second, real
interest rates have fallen on a global basis over the last 20 years.
I shall now turn to an economic concept that plays a key role in the current monetary policy
debate, namely the equilibrium real interest rate. The equilibrium real interest rate is not
directly observable and is determined by fundamentals such as time preferences and the age
structure of a society, which define the supply of savings and the demand for investment. The
SNB controls a short-term nominal interest rate. By contrast, it has only an indirect and
temporary influence on long-term real interest rates, which drive investment decisions.
Longterm real interest rates are primarily determined by saving and investment decisions and hence
by market forces.
If the central bank wishes to stimulate the economy and increase inflation, it cuts the policy
rate. Since inflation does not react immediately, real interest rates temporarily fall below the
equilibrium rate. This leads - again temporarily - to higher growth and more inflation. If, on
the other hand, the central bank wishes to curb inflation, it increases its policy rate. I
deliberately used the word 'temporarilyֹ' because if monetary policy were to target real
interest rates below the equilibrium rate on a sustained basis, inflation would go on rising but
this policy would not result in higher real growth in the long term. On the contrary,
uncertainty about the path of inflation would reduce growth potential. This is one of the
reasons why central banks are tasked with ensuring price stability. For this mandate to be
fulfilled, the policy rate must be set such that, at the desired inflation rate, the real interest rate
corresponds with the equilibrium rate in the medium term.
It is likely that the real equilibrium interest rate is lower today than in the past. The case for
this hypothesis is supported by the fact that real interest rates have been falling globally for a
considerable time because, it is argued, people are investing less and simultaneously
displaying a greater propensity to save. The propensity to save is increasing due to population
ageing. This demographic trend can be measured using the old age dependency ratio, which
measures the ratio of people over 64 to the working age population. An 'older' population has
a higher old age dependency ratio. Chart 3 shows that the old age dependency ratio in
Switzerland, as in many other countries, is rising. Pensioners live off their savings. And an
ageing population needs to save more today in order to be able to finance a specific level of
consumption in the future. Another cause of the increased supply of savings is the integration
of China into global financial markets. Savings in China are high as a result of its ageing
society and its rudimentary state pension system. In the current economic situation,
uncertainty regarding the future development of the economy in certain parts of the world
may also have pushed up the supply of savings.
While the propensity to save has increased, the willingness to invest may also have fallen. On
the one hand, this may once again reflect heightened uncertainty over future economic
conditions. On the other, expectations of lower productivity growth might also be playing a
role. Furthermore, industrial economies are being transformed into service economies, with
potentially lower capital needs.
All these factors have resulted in a relatively low real equilibrium interest rate today - across
the world, and thus also in Switzerland. Moreover, global monetary policy is expansionary
due to undesirably low inflation and subdued economic growth in the wake of the financial
crisis. The long-term downward trend in interest rates globally and expansionary monetary
policy occasioned by cyclical factors have therefore combined to produce historically low
interest rates.
Transmission channels of negative interest rates in Switzerland
Irrespective of the equilibrium rate, questions arise regarding the transmission mechanism of
monetary policy below the zero lower bound. Specifically, how does monetary policy using
negative interest rates effect a rise in inflation?
As you will probably remember from your student days, monetary policy usually operates
through a variety of transmission channels. For a small open economy like Switzerland, the
exchange rate channel is the most important. Lower interest rates, other things being equal,
make the Swiss franc less attractive as an investment currency. The franc loses value, which
makes Swiss goods cheaper abroad, and leads to a rise in net exports. This in turn raises GDP
and inflation in Switzerland. Depreciation of the Swiss franc also has a direct impact on
inflation because import prices rise.
A reduction in interest rates also operates via the credit channel. Put simply, if the SNB
reduces the short-term interest rate, longer-term market rates also fall. Loans become cheaper
and this stimulates consumption and investment. These factors boost the economy and
inflation rises.
Is the negative interest rate in Switzerland having the anticipated effect? Let me first look at
transmission via the exchange rate channel. Historically, Switzerland has always had lower
interest rates than most other countries, particularly euro area countries. The interest rate
differential reflects not only lower average inflation in Switzerland compared to other
countries, but also the country's political stability and credible monetary policy. Investors are
prepared to hold Swiss franc investments at lower yields. Chart 4 plots policy rates in
Switzerland and in the euro area. Since the outbreak of the financial crisis, the interest rate
differential has become ever narrower. When the negative interest rate was introduced in the
euro area in June 2014, the interest rate differential even turned negative.
Every subsequent monetary easing measure by the ECB added to the pressure on the Swiss
franc, which at the time was subject to the minimum interest rate against the euro. Chart 5
shows the exchange rate of the euro against the Swiss franc (blue curve) and against the US
dollar (red curve). In the second half of 2014, the value of the euro fell sharply against all
major currencies. This meant that the minimum exchange rate was no longer sustainable. The
volume of interventions that would have been required to defend the minimum exchange rate,
even just temporarily, threatened to spiral out of control. This is why we adjusted our
monetary policy in January 2015. The discontinuation of the minimum exchange rate caused
the Swiss franc to appreciate, by an amount roughly equal to the gain in value that most other
currencies had experienced against the euro in the preceding months.
Our monetary policy since then has been based on two elements: the negative interest rate of
-0.75% on banks' sight deposits held at the SNB and our willingness to intervene in the
foreign exchange market, as necessary. The negative interest rate in Switzerland has at least
partially restored the original interest rate differential and thus reduced pressure on the Swiss
franc. As Chart 6 shows, the real external value of the Swiss franc has been on a gradual
downward trajectory since mid-2015. Even in times of increased market volatility, as in the
aftermath of the British EU referendum in June this year, the Swiss franc has remained
broadly stable against the euro and the US dollar. Without negative interest and our
willingness to intervene, the Swiss franc would have appreciated, growth would have slowed,
and inflation would have fallen further.
The impact of negative interest rates on the exchange rate is crucial for us because
Switzerland is a small open economy and foreign trade is a very important factor in our
economic performance. In 2015, exports contributed over 50% to GDP, while imports
accounted for about 40%. Movements in the Swiss franc therefore have a big impact on
domestic economic developments. The Swiss franc is still significantly overvalued and this
represents a major challenge for many sectors. Imported goods and services also have a high
weighting in the Swiss consumer price index basket. The appreciation of the Swiss franc since
the financial crisis was therefore also directly reflected in the inflation rate. This has generally
been negative over the last five years, as you can see in chart 7. The biggest contribution to
low inflation, the red bars in the chart, comes from imported goods. Also, the fall in oil prices,
the yellow bars, has contributed to low inflation. Thanks to the stabilisation of both the
exchange rate and oil prices, inflation has been climbing since the end of 2015, and we
forecast that it should re-enter positive territory in the coming quarters.
Now let me turn to the credit channel. In a functioning transmission mechanism, you would
expect to see a lower general interest rate level and rising credit volumes following an interest
rate cut by the central bank. Did interest rates in Switzerland fall after the introduction of
negative interest? And how have credit volumes and bond issuance changed?
Since the reduction in interest on banks' sight deposits held at the SNB to -0.75% in January
2015, yields on long-term Confederation bonds have fallen by more than half a percentage
point, as chart 8 shows.2 Interest rates on corporate bonds, the red curve in the chart, have also
declined sharply. The financing costs of bond-issuing companies have thus fallen. The
situation regarding interest rates for bank loans is rather different. As you can see in chart 9,
initially they did not fall; indeed, they rose slightly. This seems surprising at first glance but is
attributable to the fact that banks tried to offset a further decline in their interest margin with
increased income from credit business.
Meanwhile, interest rates on mortgage loans are also lower than before the introduction of
negative interest. Thus, we can conclude that taking a policy rate into negative territory has a
similar effect, in terms of transmission to other interest rates, to cutting a policy rate in
positive territory.
Although interest rates have fallen, no significant increase in credit growth has been observed
over the last two years. The volume of bank loans to businesses and households has risen
further, as you can see in chart 10, but credit growth has weakened. This slowdown in growth
is particularly evident among loans to private, non-financial corporations. However, the
picture is different for companies that are able to finance themselves via the capital market, as
chart 11 shows. Domestic non-financial corporations have exploited the low capital market
interest rates and issued more bonds since the introduction of the negative interest rate.
As a preliminary conclusion, we may state that the negative interest rate in Switzerland
principally operates via the exchange rate channel. Together with our willingness to intervene
in the foreign exchange markets, it has helped to ensure that the Swiss franc has not
strengthened further despite heightened uncertainty, for example in the wake of the British
EU referendum. Moreover, yields on government and corporate bonds have declined since the
negative interest rate was introduced, as did mortgage rates, albeit to a lesser extent. Overall,
financing costs for households and businesses are lower today than they were before the
introduction of negative interest. Along with the rise in the volume of bonds issued, this is
evidence that negative interest is also having some impact via the credit channel, even though
growth in bank lending has not risen as would normally be expected.
Challenges posed by low interest rates
In Switzerland, therefore, negative interest rates have had the desired effect. Yet low interest
rates also present a number of challenges and potential side-effects, which I would like to
look at now.
One challenge is communication. At first glance, imposing a charge on deposits appears to
turn the logic and laws of economics on their head. It seems unnatural to pay interest on
deposits. Consequently, clear communication of monetary policy is especially important right
now. In the earlier part of my presentation, I demonstrated that negative interest rates in
Switzerland are the result of a decline in the equilibrium interest rate and the SNB's
expansionary monetary policy - a policy rendered necessary by global conditions.
Negative interest also puts a strain directly on banks, and indirectly on pension funds and life
insurance companies, which worry about their profitability and about meeting their
obligations. As I have mentioned, the SNB takes these concerns very seriously. Yet the
challenges now facing pension funds are not caused first and foremost by monetary policy.
Rather, their problems stem from the fact that pension funds have to achieve returns that are
nominally fixed and were set when the equilibrium interest rate was higher.
For banks, the negative interest rate undoubtedly represents a cost because they have to pay
interest on their deposits at the SNB. However, the SNB grants a generous exemption
threshold, which reduces the effective interest rate burden for the banking sector. These
exemption thresholds give banks the freedom to decide whether - and to what extent - they
should pass on negative interest to their customers.
From a financial stability perspective, it is not negative interest per se which poses a
challenge, but rather the low level of interest rates more generally. It is conceivable that low
interest rates will lead investors to take greater risks. This can result in imbalances developing
on the real estate and mortgage markets. In Switzerland, a variety of measures have been
implemented since 2012 - the countercyclical capital buffer for instance - with the aim of
reducing the associated financial stability repercussions. Since then, the pace of growth on the
real estate and mortgage markets has slackened somewhat, although mortgages continue to
grow faster than GDP. The SNB therefore monitors the situation on these two markets
continuously.
An environment of low interest rates also brings fundamental monetary policy challenges.
One of these arises from the fact that it is possible to hold money in the form of cash. I have
shown that the SNB's negative interest rate is an effective monetary policy tool. But how far
can nominal interest rates actually fall? If the interest rate level declines further, at some point
cash will become more attractive than sight deposits bearing negative interest. As the SNB
has no intention of doing away with cash, this results in an effective lower bound for interest
rates, which limits the scope for monetary policy action. This lower bound is below zero,
because holding cash is expensive and risky. Thus, people are prepared to pay a certain
amount to hold their money electronically. In Switzerland, the cost associated with the current
negative interest rate is clearly lower than the cost of holding cash. Consequently, demand for
cash has not yet risen substantially. So the effective lower bound for interest rates has not yet
been reached, but we know that it exists.
Another monetary policy challenge is the fact that the expansionary effects of low interest
rates on consumption and investment can fade over time. As I have noted, following the
introduction of negative interest, some banks increased their lending rates in order to offset
falling interest margins. The longer the low interest rate environment persists, the greater the
risk that distortions in the banking system will arise, hampering the transmission of the
negative interest rate via the credit channel. In addition, low interest rates on savings deposits
at banks, coupled with concerns over future pension payments, could induce households to
save more in order to achieve a specific savings goal. As a result, consumption falls instead of
rising, as one might normally expect in an environment of low interest rates. At the same
time, the increase in savings causes the interest rate level to decline further. This effect is
reinforced if households assume an increasingly long phase of low interest rates.
Despite these monetary policy challenges and potential side-effects, in Switzerland the
negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc
and the globally low level of interest rates. Nonetheless, the challenges and side-effects show
clearly that we must aim for a normalisation of monetary policy over time. The question is,
how can such a normalisation be effected?
Current monetary policy in an international context
To answer this question, I would like to place current monetary policy in an international
context.
In addition to the SNB, virtually all major central banks are currently pursuing a monetary
policy of low or negative interest rates. By dint of bold and decisive policies, central banks
have managed to prevent the global financial crisis from turning into a second Great
Depression. Yet, despite highly expansionary monetary policies around the world, many large
advanced economies have not recovered as strongly as hoped. In Switzerland, the recovery
has been relatively robust by international standards. Yet inflation in our country, as in many
other countries, is still lower than we would like. So the past few years have shown clearly
that an expansionary monetary policy is not a panacea for catalysing growth in the major
advanced economies. Expansionary monetary policy is no substitute for necessary structural
measures and it must not delay them.
Monetary policy influences the economy's growth potential only insofar as price stability
reduces uncertainty. Beyond this, it has no effect on economic growth in the longer term. For
this reason, longer-term growth prospects can only be improved through structural measures.
For instance, the promotion of education, research and development can increase productivity
growth. Good economic conditions support growth: if entrenched labour market structures are
dismantled, competition is encouraged, and contracts are reliably enforced, the economy
becomes more efficient. A pension system that is sustainable in the long term can allay
people's fears about an uncertain income in their old age, and thereby avoid an excessive
propensity to save.
If such reforms in the major world economies are successful in positively influencing
expectations about future income and returns, then global demand for consumption and
investment could rise today. In this way, structural reforms in the major economies can also
contribute to a normalisation of the interest rate level and monetary policy worldwide -
including in small open economies. In principle, structural measures that result in higher
productivity growth, a lower propensity to save and a greater willingness to invest will
increase the equilibrium interest rate. Absent a change in monetary policy, such an increase
means that monetary conditions will become more expansionary. This would further
encourage economic recovery and facilitate the implementation of these structural measures.
The central banks could then gradually raise policy rates again, and the undesirable
sideeffects of low or negative interest rates would be contained.
Conclusion
To conclude, let me sum up my remarks in five core messages.
First, the low level of interest rates is a global, secular phenomenon. Real interest rates have
fallen worldwide, and have been doing so steadily for the last 20 years. This suggests that the
equilibrium real interest rate has declined. Underlying this are demographic trends and altered
behaviour on the part of consumers and companies, which have resulted in a higher supply of
savings and lower investment demand.
Second, although negative nominal rates are often perceived as unnatural, the laws of
economics are not inverted once the zero lower bound is breached. In principle, taking a
policy rate into negative territory has a similar effect to cutting a policy rate in positive
territory. In Switzerland, the negative interest rate has its main impact via the exchange rate
channel. Together with the SNB's willingness to intervene on the foreign exchange market as
necessary, the negative interest rate policy has prevented further Swiss franc appreciation and
has generally helped to reduce pressure on the currency.
Third, in an environment of low interest rates worldwide, the negative interest rate is
necessary and appropriate for Switzerland. As a small open economy, Switzerland cannot
decouple itself from the global low interest rate situation. What would have happened if the
SNB had not introduced negative interest? The Swiss franc would have appreciated even
more strongly, there would have been a slowdown in growth accompanied by even lower
inflation, and unemployment would have risen.
Fourth, a phase of low interest rates, especially a prolonged one, can have undesirable
sideeffects, including the possibility of cash hoarding, which limits the scope for monetary policy
action. There can also be undesirable consequences for financial stability, which should not be
underestimated. These challenges and side-effects will amplify, the longer interest rates
remain low.
Fifth, against this backdrop I would like to emphasise that negative interest, or expansionary
monetary policy in general, is no panacea. For a sustained economic recovery, adjustments in
the real economy are necessary. Structural measures in the major economies can create the
conditions for equilibrium interest rates worldwide to rise once more. This would also allow
central banks to embark on a gradual process of normalisation, and the potential adverse
effects of persistently low interest rates would be contained.
Thank you for your attention.
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