The Pros And Cons Of Negative Interest Rates Policy (NIRP)

As central banks go deeper into unconventional policies, there is increasing speculation that more of them will engage in negative interest rates policies (NIRP). Even the Fed may consider this. We therefore pull together some of the latest academic thinking on the topic. In this Deep Dive, we focus on two papers one by the ECB and another by some Swedish academics. As you’d expect the ECB paints a more positive light, which is not surprising as they have maintained their NIRP policy. The Swedish analysis, however, argues that NIRP promotes financial bubbles, and therefore should be used with caution.

The ECB View

Given the ECB has maintained negative rates, their analysis would naturally suggest it has worked. According to their studies, for the period 2014-2019 (ECB first cut rates to negative in 2014), they found that financial markets responded positively to the move to negative rates:

• Short-term euro-area yields followed the 50 basis point reduction in the Deposit Facility Rate at a level of almost one for one. EONIA rates in the interbank market also fell.
• Ten-year yields declined by around 130 basis points over the same period, i.e. exceeding the decline at the short end of the curve.
• Investment grade corporate bond yields of non-financial corporations (NFCs) decreased by roughly 120 basis points.
• Euro area equity prices increased by close to 25%.

As for the broader economic impact, they found the following:

• Overall empirical evidence points to a loan growth of 0.7 percentage points a year, authors claiming this assessment is corroborated by survey evidence from the euro area BLS.
• The study mentions that “on average, 10% of banks in net percentage terms reported that the negative Deposit Rate Facility led to an increase in loan volumes to enterprises”.
• For households and house purchases, the figure was 15%. When it comes to lending rates, around 40% of the banks reported a compression for lending rates in net terms for both enterprises and households for house purchases.
• Across the entire package of unconventional tools, they estimated that NIRP was responsible for one-sixth of the overall cumulative impact of policy on GDP and inflation.
• Eurosystem staff estimates that the whole unconventional package led to an end-of-2019 GDP that was between 2.5 and 3.0 percentage points higher than it would have been in the absence of it. Similarly, the contribution for inflation is estimated to have been between one third and one half of a percentage point per year until 2019.
• Firms shifted from liquid assets to non-financial investment. Their analysis found this corporate channel added 1 percentage point to aggregate business investment. A survey made of 500 German firms conducted in July-August 2019 pointed that in the face of negative rates, 32% of firms invested more in their own business.

The biggest criticism of negative rates is that banks are unable to pass on negative rates to savers, and therefore bank profitability would fall, which could impinge on credit creation. Again, the ECB has not found a negative impact:

• Net Interest Income – the main component of bank profitability – has remained resilient as larger intermediation volumes offset lower margins.
• They find that while negative rates hurt net interest income, banks gained from asset appreciation on their balance sheet and lower loan loss provisions when compared to the counterfactual of no NIRP (Chart 1).
• Apart from consumer spending which indeed “showed signs of exuberance”, the ECB found that “easing of margins on riskier loans have been much more contained than on average loans and, over the last year, margins on riskier loans have actually been tightening”.
• Also, “the increase in the risk profile of portfolios has been adequately reflected in lending rates”. Results come from the euro area bank lending survey (BLS). So far, those developments show that financial stability matters can be kept under control.

That said, the ECB analysis does recognise that the positive gains for banks from NIRP are unsustainable over the long run.  Over time, there would be a decrease in income from earlier fixed rate loans that mature and then get fixed at new much lower rates. This could then lead to banks cutting costs to maintain profitability.

Chart 1: Changes in Bank Profitability Between 2014 and the Third Quarter of 2019 and NIRP Impact

Source: ECB

The Swedish Counterpoint

Sweden was the first to exit negative rates and recent academic work from Sweden gives some context for caution.

The starting point of their analysis is February 2015 when negative policy rates were introduced in Sweden. While they acknowledge that the inflation target was back on track at 2% by the end of 2018, they are not at all confident this was the result of the NIRP. They find Swedish inflation was tied to the turn in the Euro-area business cycle than the Swedish one.

Instead, Swedish NIRP was procyclical and so inflated house prices and household debt levels. Property prices rose by close to 50% in relation to disposable income (between 2012 and 2016). This increased inequality and the Swedish financial supervisory authority had to introduce forms of credit controls to contain the bubble. In addition, the Swedish krona depreciated by 10% with no major impact on domestic inflation.

They conclude by saying that the avoidance of negative rates would have left a better balanced Swedish economy in terms of asset price inflation, less fiscal imbalances and more room for further reaction.

Bottom Line

The advantage of NIRP appears to be that it lowers interest rates across the curve, it supports asset markets and can weaken currencies. However, there does appear to be a longer-term cost to banks, even the ECB recognises that. In the short-term, banks can benefit from the turn in asset markets and lower loss provisions, but eventually, the lower net interest margins will lead to cost-cutting. Moreover, at least in the case of Sweden, the boost to asset markets could tip them into bubble territory, so NIRP may need to be coupled with macro-prudential policies to contain those.

Stefan Posea is a Research Analyst at Macro Hive. His research interests lie in macro-financial interactions and monetary policy analysis. Stefan graduated with an MSc in Economics at Birkbeck, University of London and previously held roles in M&A and the Public Sector.