The Unintended Consequences Of Central Bank Policies & Negative Interest Rates
While many pundits seem to heap praise on the policies that central bank policies introduced after the 2008-2009 financial crisis, their actions came with unintended consequences. Sometimes they were the exact opposite of the outcomes desired.
Central bank efforts to push the cost of borrowing below zero percent seem to have backfired, according to new research. In particular, when one monetary authority tried it the result was that banks made fewer commercial loans and economic output fell.
The stated goal of most central banks after the financial crisis was to help boost the creation of credit in the global economy and so increase economic output. But if the research is correct, those sub-zero interest rate policies didn’t just miss the bullseye but instead shot the bankers in the foot.
That’s something that all central bankers should study especially the European Central Bank, which along with others pursued a policy of negative (sub-zero) interest rates.
This article is the second of a two-part series on the ECB which deals with the effect of negative interest rates on economic output. For part one, on distortions in the bond market, click here.
Most of the time interest rates are above 0%. That means that when you put money in the bank, you get back at least what you deposited and then some more in interest payments.
Negative interest rates turn that concept on its head. For example, when interest rates are below 0% a year, then a depositor would receive less cash back at the end of the year than they put into their account at the beginning. For a more comprehensive discussion, try reading a series on the topic that I wrote a few years ago here.
New research now shows that when central banks push rates below zero, it can have bad effects on the economy.
“[…] we showed that a negative policy rate was at best irrelevant, but could potentially be contractionary due to a negative effect on bank profits,” states the paper titled: “Negative Nominal Interest Rates and the Bank Lending Channel,” by researchers at Harvard University, Brown University, and Norges Bank. The authors include Lawrence Summers, former U.S. Secretary of the Treasury and one-time president of Harvard.
In simple terms, when a central bank decides to pursue a policy of making interest rates lower than zero (a.k.a. negative), then the effects could shrink the economy rather than grow it. That’s because negative interest rates destroy the profitability of banks, especially those that rely on customer deposits to make loans.
The paper continues by explaining that the normal channel through which changes in official interest rates gets transmitted to the economy breaks down when the central bank makes rates negative.
The negative rates are a problem for financial institutions, especially those that still need to attract customer deposits to fund the loan-making business. It’s easy to understand this phenomenon when you ask yourself if you’d put cash in the bank knowing that your money’s value would decrease over time. That prompts banks to keep deposit rates at a minimum of zero (0%) even while the central bank is trying to lower the cost of borrowing.
That’s what the researchers found happened in the real world when they studied the world example of the policies of the Riksbank, Sweden’s central bank:
Using daily bank level data, we document that once the deposit rate becomes bounded by zero, interest rate cuts into negative territory lead to an increase rather than a decrease in lending rates.
It ultimately led to higher cost loans, even though the central bank was trying to make them cheaper. The policies also retarded economic growth. The researchers used the example of Sweden’s central bank, the Riksbank.
“A calibration which matches Swedish bank level data suggests that a policy rate of -0.50 percent increases borrowing rates by 15 basis points and reduces output by 7 basis points,’ the report states.
In simple terms that means that the cost of a loan went up by one-sixth of one percent when the Riksbank cut its rates to minus 0.5%. The knock-on effect is a fall in economic output by less than a tenth of a percent.
While these effects are relatively small, it should be evident that they are in the opposite direction to that which any central bank would have wanted in the aftermath of the financial crisis. That was when lack of credit (affordable or otherwise) in the financial system was choking off the world economy.
The report concludes with a telling summation:
Our findings suggest that negative interest rates are not a substitute for regular interest rate cuts in positive territory, at least to the extent that these cuts are expected to work via the bank lending channel.
In other words, it might be best to bin any ideas of using negative interest rates as a future policy tool.
The ECB declined to comment, and the Riksbank did not respond to requests for comment.
For part one of this series, on distortions in the bond market, click here.