Do Negative Rates Work? Yes, But Not by Much
December 22 2019 - 10:29AM
Dow Jones News
By James Mackintosh
Federal Reserve policy makers opposed to taking interest rates
negative in the next recession might take comfort from the end of
Sweden's dalliance with below-zero rates.
But investors shouldn't expect the neighboring eurozone to
follow suit: Just hours after the Riksbank raised its policy rate
back to zero on Thursday, a group of the most senior
monetary-policy staff at the European Central Bank published a
long-awaited paper robustly defending negative rates. The
eye-catching claim: The benefits for the economy would still
outweigh the damage even if rates went twice as negative, to minus
1%.
Sweden's Riksbank warned of harmful side effects from prolonged
periods below zero, even though it agrees with the ECB that
negative rates have helped the economy so far by lowering borrowing
costs and boosting inflation.
But which of them wins the argument about the future could be
vital for the future use of rates below zero, something even the
Fed might have to reconsider if they again hit zero in the next
economic downturn.
The disagreement is over what happens if rates stay low for a
long time. In its monetary policy report on Thursday, the Riksbank
said if negative rates are widely expected to last, "the behavior
of economic agents may change and negative effects may arise."
The side effects of negative rates have been well rehearsed by
the skeptics: Bank margins are squeezed if they can't pass on the
negative rates to their own depositors; pension funds and insurers
forced by regulators to hold negative-yielding government bonds
will find it hard to meet promises to customers; and the prospect
of better-than-free money may encourage financial and housing
bubbles.
The Riksbank didn't go into detail about its concerns. But the
worries are serious enough for the central bank to raise rates even
as it acknowledged that the economy was weakening -- although it
continues to buy bonds and promised no further rate increases for
years.
The ECB paper led by Massimo Rostagno, head of the bank's
monetary policy division, insists that negative rates, alongside
bond buying, forward guidance and cheap long-term loans to banks,
provide multiple benefits.
First, it argues, demonstrating that there is no zero lower
bound to rates takes away the fear that central banks are powerless
to act when rates hit zero.
Second, negative rates -- a charge on commercial bank deposits
at the central bank -- create a "hot potato" effect. Banks are
encouraged to lend out or invest their money to avoid paying the
ECB to hold their spare reserves. The banking system as a whole
can't escape the cost of negative rates, since the reserves have to
end up back at the ECB in the end. But any individual bank with
spare money can hope that if it is used to buy bonds or lent out,
the recipient will pay it into an account at a rival, which will
then have to take the hit from the ECB.
Third, the research found that cuts to rates when they are
negative lower government bond yields more than cuts when they are
positive. The biggest effect is on five-year bonds, which heavily
affect fixed-rate lending. The explanation is tricky; one
possibility that rather undermines the case for negative rates is
that investors think things must be really bad for the central bank
to try out even deeper negative rates, so expect rates to stay low
for a long time. It's easy for a central bank to cut rates in
normal times, so they are usually expected to rebound toward a
higher steady state within a few years.
Fourth, the negative rates helped other policies, such as
forward guidance and corporate bond purchases, be more
effective.
Finally, a model used in the study concludes that banks have
made more money with negative rates than they would have if rates
hadn't been cut, and will continue to do so. This seemingly
counterintuitive conclusion results because the squeeze on bank
margins has been more than offset by rising fees, capital gains and
lower provisions for losses than would have been the case.
It is possible to pick apart each point. But even for those who
buy into the methodology, it is far from clear that negative rates
are worth the uncertainty or the political angst. The study tries
to break apart the effect on inflation and growth, and it concludes
that negative rates were less effective than bond buying, forward
guidance or cheap loans -- and pushed up inflation by up to 0.07
percentage point a year (see chart).
Every little bit helps, and this is a conservative estimate. But
the rewards seem small given the danger that prolonged negative
rates could either inflate a bubble or start to hurt banks,
insurers and pension funds.
I'm with the Riksbank: Negative rates can help the economy, but
the side effects are likely to increase the longer they stay
negative. So it's best to keep it as a short-term experiment.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
December 22, 2019 11:14 ET (16:14 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.