Deflation, central bank impotence, and negative interest rates
Low inflation continues to be a concern in the eurozone as it falls back into negative territory (Eurostat, as reported by DW), on the backdrop of falling oil prices and slowing economic growth. Francois Villeroy de Galhau (interview) warns that deflation is the main danger for the euro zone. EuroIntelligence highlights that after a year of quantitative easing in the eurozone, the rate of core inflation is unmoved, and inflation expectation indicators have been moving lower. They write that unless there is a very significant change in monetary policy, this will suggest that the ECB is no longer committed to the 2% inflation target.
The debate about central banking effectiveness
Jeremie Cohen-Settong (Bruegel) investigates the debate about the impotency of central banks in a recent blogspot—a concern noted by Leo Grohowski, William Watts, Bill Gross, and John Plender, among others, with difficulty to assess the impact of all the recent monetary experiments (Noah Smith). Dieter Wermuth writes (blog Herdentrieb) that despite all unconventional measures employed by central banks around the world, the economy remains in a liquidity trap—as high debts and deleveraging limit the effectiveness of monetary policy.
The unintended consequences of negative rates
Moving to very negative policy rates is not without risks (see Nikolaos Panigirtzoglou at JP Morgan), with discomforting evidence from Switzerland and Denmark. Potential unintended consequences of very negative policy rates include:
Lower bank profitability—More negative policy rates will weigh on bank earnings (a point that was recognized by ECB board member Benoît Cœuré (speech), especially if it is difficult for banks to charge negative rates on retail deposits, according to Huw Pill and Saba Alam (Goldman Sachs), creating a new ‘effective’ limit on the ability of the ECB to cut rates. The BIS published a report warning of risks associated with negative interest rates (see the FT) (rebuked by Kuroda in a recent speech)—because of the unknown on how borrowers and savers would react or whether the channels through which central banks’ rate moves are usually passed on to the broader economy would “continue to operate as in the past,” and because of serious consequences for the financial sector (note that the Wall Street Journal and Frankfurter Allgemeine are criticizing the EBA’s guidelines for the stress tests because of the absence of negative interest rate shocks). The viability of banks’ business model as financial intermediaries may be brought into question. Danièle Nouy (hat-tip EuroIntelligence) suggested that, given that the low-interest environment is likely to persist, to improve profitability, rather than invest in risky high-yield investments, a shift in business models towards fee revenue may be needed (a trend resisted by French banks).
For Martin Sandbu, there is, in practice, no lower bound on interest rates and no hard evidence that the impact on bank profits is so extreme that it would affect credit (a point also made by David Keohane at FT Alphaville). He contrasts the impacts on the yield curve: QE flattens it, thereby reducing the incentive for long-term investments since there is less to gain for locking up capital while negative rates steepen it, increasing the effectiveness of QE.
Higher bank lending rates and reduced credit creation to the real economy—Panigirtzoglou argues that making rates more negative does not improve credit creation nor lowers lending rates.
Impaired functioning of money markets and reduced liquidity in bond markets—collapse in money market volumes reflects that when negative deposit rates are combined with significant increases in liquidity, the functioning of money markets can become problematic.
Increased fragmentation—the share of cross-border unsecured overnight interbank activity stopped improving in 2014 and Target 2 balances deteriorated, as banks take less risk.
Signaling effects can also be costly. According to Goldman Sachs, the prospect of further cuts in central bank policy resulting in rates going deeper into negative territory has had an adverse impact on investor confidence in banks. An adverse investor response towards the impact of such policy easing on European banks may reduce the effectiveness of the rate cut in stimulating demand (and ultimately in achieving the ECB’s price stability objective). Narayana Kocherlakota writes that negative rates will only be an effective form of stimulus if they are treated as being fully conventional, with no zero lower bound and clear communication—to avoid sending bad signals and perception that central banks have lost control of inflation (Jared Bernstein).
Negative rates are ineffective in creditor countries, according to Daniel Gros (CEPS commentary): the US and the UK are debtor countries, benefiting from negative rates, while the eurozone and Japan are creditor countries, where negative rates have little effect—especially as lower rates reduce savers’ income, reduce their spending, and may increase savings. He argues against further potentially counterproductive monetary easing, and to instead let the recovery to run its course.
How to enhance the effectiveness of negative rates?
The impact of negative rates depends crucially on the ability to pass them on to retail and corporate depositors, as argued by Mark Cliffe (VoxEU). He notes a survey in which a large majority of respondents said that they would withdraw their savings, and yet few would spend more: the aversion to the prospect of negative rates raises troubling questions about the potential effectiveness of this policy tool. To avoid the hit to bank profits and ensure pass through, central banks need to find some way of freeing up household and retail deposit rates ("stickiness at zero rates") (with a partial success in Denmark on corporate deposit rates). Without relaxing this constraint, the hit to bank earnings and possibly even higher lending rates will make NIRP unviable—yet this is difficult to achieve without price controls (and their distortions) and politically. Peter Fisher (at BlackRock, Bloomberg) laid out the reasons why sub-zero interest rates will prove counterproductive on three key channels. First, foreign exchange—for large economies, it is simply a costly game of competitive devaluation. Second, credit—he suggests looking at the supply-side (not demand, which will be bolstered by cheaper rates), i.e., whether net interest margins make it attractive for lenders to provide these funds, and this depends on the direct charge on deposits and the flattening of the yield curve. Third—wealth effects: but if the tax on bank deposits is also levied on consumers, the effect is negative on wealth. This raises a question: if deposit rates indeed downwardly sticky at zero, this may give some extra room for the ECB to go more negative, following the Nordic countries, but with a clear adverse effect on bank margin.
A multi-tiered remuneration of excess reserves as a solution? It can help (as discussed here) as only a portion of bank reserves is subjected to very negative interest rates. Subjecting even a small portion of reserves to the lower deposit rate could be enough to push interbank rates or bond yields lower. Yet this still reduces net interest income especially if interest rates move deeper into negative territory given the inability to pass negative deposit rates to retail customers. Francesco Papadia and Guntram Wolff are strongly dismissive of a tiered deposit-rate system.
How low can negative rates go? For Goldman Sachs, this is determined by the 'cash arbitrage' constraint (and their research and here puts it around -0.5%), compounded by bank profitability concerns. Stephen Cecchetti and Kermit Schoenholtz note that what determines how low interest rates can go is not the cost of cash storage, but insurance, which is simply not available for large amounts. They argue that if negative rates become part of the monetary policy toolkit, an inflation target of 2% may not be too low after all. A JP Morgan report by Malcom Barr, Bruce Kasman, and David Mackie is sanguine about how low the lower bound for negative policy rate could be. They argue that using tiered deposit schemes could allow rates to go as low as -4.5% without undue pressure on bank profitability or creating a powerful incentive to move into cash.
The need for complementary policies…Higher demand will be crucial to benefit from negative interest rate policies, hence requiring coordinated fiscal, monetary and structural action. Lorenzo Bini Smaghi (hat-tip EuroIntelligence) argues that the issue is the excess of desired savings over investment, a problem that monetary policy is not particular suitable to address, and needs to be accompanied by other supporting policies—structural reforms. Stephen Roach (Project Syndicate) is negative about negative rates, which according to him, by driving stimulus through the supply side of the credit equation, miss the need to focus on the demand side in the aftermath of a “balance sheet recession.” With unconventional monetary policy, the transmission channel runs mainly through wealth effects from asset markets, with two serious complications: risks of financial instability and less political inclination for fiscal stimulus.
… Or alternative monetary policy tools, such as helicopter money. EuroIntelligence dismisses Francesco Papadia and Guntram Wolff’s suggestion that structural reforms are the only policy option, suggesting that helicopter money may be an alternative—the prospect of which is close according to Martin Wolf: current policy tools are ultimately versions of beggar-thy-neighbor policies working through the exchange rate channels; with little expectations of a loosening of fiscal policy, helicopter money will become a key option. Simon Wren-Lewis addresses two confusions in the debate on helicopter money: (i) helicopter money, because it raises demand, does not necessarily need to lead to lower interest rates; (ii) it is complementary to fiscal expansion. If governments cannot be trusted to deploy countercyclical fiscal policies, or not on a large enough scale, then helicopter money acts as an insurance policy.
What options for the ECB going forward?
What can the ECB do to fight deflation—negative rates vs. asset purchases? Gregory Claeys and Alvaro Leandro (Bruegel) write that, despite a series of changes to the QE program (universe of purchasable assets and flexibility in execution), this might not be enough to sustain QE throughout 2017 and it may have adverse consequences. They conclude however that the benefits of QE still outweigh its possible negative implications for financial stability or for inequality. Francesco Papadia and Guntram Wolff (Bruegel) argue that the ECB still has some instruments left—in particular, while increasing sovereign debt purchases would be ineffective (a negative marginal effect of more QE, illustrated by waves of QE in the US) and pose risks (notably on banks), moving purchases towards new assets, though it may add risk to the ECB’s balance sheet and create a conflict of interest with its role as bank supervisor, could be a better option. They suggest three other major policy tools: helicopter money, outright fiscal policy (but politically not in the cards in the eurozone), and stepping up work on structural policies.
Market analysts (e.g., Dirk Schumacher (Goldman Sachs), Marco Valli (UniCredit)) expect a substantial easing package at the March 10 ECB meeting, as the growth and inflation forecasts will be significantly revised downward: (i) the rate on the ECB’s deposit facility to be cut by 10bp to -40bp (a compromise with those who have concerns about the negative impact this may have on the banking sector); (ii) the announcement of an introduction of a tiered rate system for reserves (to partially address concerns about the impact of negative rates on banks), although the new system may become effective only at a later stage; (iii) the volume of monthly purchases to be increased by €10bn to €70bn (with two purposes: strong signaling and raising the overall effectiveness of monetary policy in lowering funding conditions for the private sector (as assessed by the ECB here).; (iv) the parameters of the Public Sector Purchase Program (PSPP) to be left unchanged but the prepared statement and/or Mr Draghi's comments during the press conference to stress that the PSPP parameters can be changed in principle if necessary.
