Why negative rates sometimes succeed

Posted on September 5, 2016

Mandatory Credit: Photo by Kim Petersen/imageBROKER/REX/Shutterstock (4980978a) The new Horseshoe apartments, development area of Orestad, Amager, Copenhagen, Denmark VARIOUS©Kim Petersen/REX/Shutterstock

Income boost: in Denmark, which has negative rates, some homeowners now receive — rather than pay — interest on their mortgage each month

When the European Central Bank’s top officials gather in Frankfurt this week, they will confront a dilemma that has only grown more difficult over the summer.

Bankers in Germany and elsewhere are up in arms about the ECB’s ultraloose monetary policy — most of all, negative interest rates that have crushed many institutions’ profit margins

    But the lacklustre recovery has also led prominent economists to urge the eurozone’s monetary authority, and its counterparts elsewhere, to go further in their actions rather than reining them in.

    A report last week by the International Centre for Monetary and Banking Studies and the Centre for Economic Policy Research
    concluded that interest rates should be cut further below zero and asset purchases expanded.

    “Any side-effects are manageable and not of a magnitude to justify timidity,” said the study, known as the Geneva report and written by four senior economists.

    While the debate between partisans and opponents of negative rates has become steadily more impassioned, in practice the effectiveness of such policies often depends on the characteristics of individual economies.

    Factors such as how banks finance themselves, the prevalence of private pensions, the strength of national currencies and the use of alternatives to cash are particularly important.

    Such variables can decide whether negative interest rates feed through into the general economy or fall far short. They help explain the differences between the seven regions that have experimented with the policy since 2012: Denmark, the eurozone, Switzerland, Sweden, Bulgaria, Japan and, most recently, Hungary.

    Policy rate for the following central banks over time - ECB, Swiss National Bank, Bank of Japan, Danmarks Nationalbank, Swedish Riksbank


    In Denmark, for example, some homeowners
    now receive — rather than pay — interest on their mortgage each month, while in the eurozone the boost for ordinary consumers has been far less. And while negative rates have weakened the Swedish krona, making exports more attractive, there has been no comparable effect in Japan.

    Banks have found it more difficult to pass rate cuts on to borrowers in countries where they are highly reliant on retail depositors for financing. If financial institutions want to cut rates charged to borrowers without squeezing profit margins, they must also cut interest paid to depositors — or find other ways of boosting revenues.

    Some banks in countries such as Ireland, Denmark and Switzerland have started to charge companies for holding deposits but most seem less willing to charge individuals — perhaps because they fear permanently losing customers. In Japan, it has even been suggested such charges could be illegal.

    Banks in Germany, Italy, Portugal and Spain are heavily reliant on retail depositors. But in France and the Netherlands institutions have more varied sources of financing while Nordic banks get an extremely low share of their funding from deposits.

    The ECB is seeking to mitigate the problem through cheap loans that provide commercial banks with as much as €27bn in alternative financing, through its targeted longer-term refinancing operations (TLTRO) programme.

    Another problem is that negative, or very low, interest rates make it harder to accumulate assets needed to provide private retirement incomes. This may, perversely, lead people or their employers to save rather than spend more.

    This is a serious concern in the UK, where Mark Carney, governor of the Bank of England, describes himself as “not a fan” of negative rates, and where many people rely on private pensions for retirement income. But in most of continental Europe pensions are still provided by the state through unfunded, pay-as-you-go schemes.

    Guntram Wolff, director of Bruegel, a Brussels think-tank, says that in such countries, one would “almost expect the opposite” of the effect in the UK. Loose monetary policy that boosts the economy and employment should make pay-as-you-go pension schemes easier to sustain, so reducing individuals’ concerns about future pension income. In Germany, around two-thirds of pension income comes from the state.

    Negative interest rates can also bring about a currency depreciation, increasing imported inflation and export demand. Denmark and Sweden benefited in this way when interest rates were cut. But it has been a different story in Japan. The yen continues to be viewed as a haven, attracting foreigners despite negative interest rates.

    One final factor plays a big role in determining the success or otherwise of negative interest rates: notes and coins.

    As long as people have access to cash, they may be able to avoid negative interest rates, limiting the scope for central banks to cut interest rates much further.

    But the importance of cash varies across countries. Sweden, where negative rates are seen as relatively successful, is closer to being cashless than many other economies. The cost of storing cash is lower in the eurozone and Switzerland, which both have very high denomination banknotes — the €500 and SFr1,000.

    Chart: Outstanding paper currency

    The authors of last week’s Geneva report argue that as economies evolve, even this constraint on the effectiveness of negative rates may fade.

    “An abrupt abolition of cash . . . is not practically or politically realistic, but some day we may live in cashless economies,” they wrote. “If cash ceases to exist . . . central banks can make nominal interest rates as negative as needed to spur recoveries from recessions.”

    Additional reporting by Ralph Atkins, Robin Harding and Claire Jones

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