Negative Interest Rates: The Future of the UK’s Expansionary Monetary Policy?
By Joe Marshall, Kelly Ding and Sarah Wang
One of the primary functions of a central bank is to conduct expansionary monetary policy. The most obvious way to achieve this goal is to lower the nominal interest rate, which is directly under their control. The rationale for this is clear: lower nominal interest rates command lower returns on assets stored at banks. This should induce people to store less money in banks and use this money for immediate consumption; save less, spend more. It follows that lowering the nominal interest rate is a powerful tool that central banks can use to stimulate economic expansion. An important question arises: how much room is there to cut nominal interest rates? At a recent society event, external member of the Monetary Policy Committee at the Bank of England, Dr Gertjan Vlieghe, argued that the space to cut nominal rates has become drastically constrained post-Great Financial Crisis (GFC) . Vlieghe’s argument is as such: individuals holding more debt, an ageing population with increased savings, and a rise in inequality ensuring more wealth in the hands of the wealthy, have all contributed to a decrease in the riskiness of investments in many advanced economies. This is reflected by a fall in the real interest rate. Then for a given level of inflation expectations, by the Fisher equation, this corresponds to a fall in the nominal interest rate:
Consider the recent history of the UK’s nominal interest rate (bank rate) for example:
Like many economies in the past 10 years, the UK finds itself in a peculiar position: should they wish to induce further economic expansion from lowering nominal interest rates, they may need to consider dropping rates below 0. It should be said that negative interest rates are not the only expansionary tool that economies are left with. As Vlieghe also described, central banks can manufacture more room for interest rate cuts by increasing inflation, or economies could rely more heavily on fiscal stimulus (as we have seen in the US for example). Nonetheless, in the early stages of the pandemic, given the dire condition of the UK’s economy, it should come as no surprise to hear that the BoE was actively considering a negative interest rate policy (NIRP). In a speech earlier this year, Silvana Tenreyro (an external member of the Monetary Policy Committee and Professor of economics at the LSE) addressed that “we always keep our toolkit under review, and given the events of 2020, I am sure it is not surprising that those discussions continued over the year.” (Tenreyro, 2021). This article will attempt to mimic the discussions that the BoE had in early 2021, and will continue to have in the coming years, by drawing on the successes and failures of economies with NIRP, whilst returning to the opinions of Dr Gertjan Vlieghe.
First, however, we introduce a theory of inflation expectations, which will prove critical in understanding the effectiveness of NIRP.
A Theory of Inflation Expectations
Inflation expectations refer to the rate at which firms and households expect prices to rise in the future. They determine actual inflation, and hence are extremely important. The relationship between inflation expectations and actual inflation is typically introduced through a Phillip’s curve framework. Let be π actual inflation, πᵉ be inflation expectations, u be actual unemployment, uⁿ be the natural rate of unemployment, ϵ be some supply shock, and β be some positive real parameter. Then the so-called Phillip’s curve describes a downwards sloping relationship between inflation and unemployment: π = πᵉ-β(u-uⁿ) + ϵ.
The one-to-one relationship between inflation expectations and actual inflation is intuitive. If firms expect higher inflation, they will set a rising path for the prices of their goods. As all firms do so, this results in higher inflation. If households expect higher inflation, they demand higher wages, which raises the marginal cost of firms, again, giving rise to higher prices. In both cases, we have a self-fulfilling prophecy: expecting inflation causes inflation. Therefore, controlling long-run inflation requires strict control over long-run inflation expectations. In the academic literature, the control over long-run inflation expectations is known as “anchoring”. For the reasons above, almost all modern central banks have devoted an enormous number of resources to maintain “well-anchored inflation expectations”. By which they mean their citizens understand and expect inflation to sit at their inflation target. For example, if you are a UK citizen, 2% inflation should sound all too familiar; you have been anchored.
As well as ensuring stable long-run inflation, well-anchored inflation expectations are imperative for NIRP to trigger economic expansion. Investment and consumption decisions are based on the real interest rate. A lower real interest rate corresponds to a lower marginal product of capital, so lower returns to investments. Individuals in low real interest rate climates therefore prefer to consume rather than invest, giving rise to more immediate economic expansion. As motivated in the introduction, the room to cut nominal rates and therefore real rates has fallen. One way to expand this room, as per Fisher’s equation, is to keep inflation expectations high. However, inflation expectations declined after the introduction of NIRP in Japan (Christensen & Spiegel, 2019). That is, NIRP seeks to induce immediate economic expansion, but in Japan, NIRP contributed to their already problematic history with low inflation. We will explore this in more depth later in the article, but for now, the link between NIRP and inflation expectations should be clear. NIRP could be a very dangerous game to play.
The Negative Rates Club
To date, 5 central banks have implemented NIRP, the so-called negative rates club:
Each central bank had its own economic history, its own rationale for implementing NIRP, and its own experiences (both positive and negative) with the policy. This gives rise to a serious external validity problem when attempting to draw parallels between these central banks and the BoE. However, this is one approach that the BoE has been taking and the approach we will take too. Specifically, we will consider 3 members of the negative rates club, each with their own exciting and insightful narratives: The Swedish Riksbank, the European Central Bank (ECB), and the Bank of Japan (BoJ).
The Swedish Riksbank
Being the first central bank to adopt negative rates, discussing Sweden’s experience is a good place to start. The Swedish Riksbank introduced a negative deposit rate for commercial bank holdings in 2009, with its main policy rate dropping below zero in 2015 and then returning to positive territory in 2019 (the first of the 5 central banks with negative rates to end their experiment) (Andersson & Jonung, 2020). One of the few things macroeconomists agree on is that attempting to decipher long-run impacts from a 6-year-old policy is difficult, if not impossible. Nonetheless, many attempts have already been made to address the short-run impacts of Sweden’s experiment.
The key to Sweden’s narrative is that they were already in a time of expansion when their NIRP began in 2015. Their objective was not to foster economic expansion, but rather to battle their below-target inflation that they had been suffering from for many years. As is to be expected, expansionary policy on an already expanding economy stimulated the classic symptoms of overheating (Andersson & Jonung, 2020). To that extent, considering Sweden as a case study for how the UK should conduct expansionary monetary policy in response to the COVID-19 induced recession is limited, given that the UK needs to expand and Sweden did not. That being said, lessons can still be learnt from Sweden about some of the adverse effects of NIRP believed to hold irrespective of expansion or contraction.
NIRP has dramatic impacts on banking profitability and financial stability, as we will see in the section on the ECB. For Sweden, one financial intermediary hit particularly hard by NIRP was their pension industry. When a central bank drops rates below zero, financial intermediaries pass these rates on to their customers. With pensions however, the transmission of negative rates to the customer is practically non-existent (Rajan, 2020). Essentially, it is very difficult, both legally and to maintain strong customer relations, for pension firms to charge their customers for holding their lifetime savings with them. Such intermediaries are left with increased costs from decreased returns to their own investments and an inability to pass these costs on to their customers. Consequently, Sweden’s pension industry entered a so-called “doom loop” as firms struggled to generate sufficient returns when bond yields turned negative (Bloomberg, 2020).
Extending this argument gives rise to a debate that NIRP could even be contractionary. If interest rate transmission is seriously constrained, the resulting financial frictions and impact on banking profitability could outweigh the increased consumption induced by NIRP. There is conflicting empirical evidence on whether NIRP is expansionary or contractionary on aggregate, arising from varying sampling methods across Europe (see the society’s other article on NIRP for more detail on this). Given that there is potential for NIRP to be contractionary thus contradicting its own rationale and a certainty that NIRP is detrimental for industries where interest rate transmission is particularly inhibited (for example the pension industry as seen in Sweden), the UK must pay close attention to these industries should their rates turn negative.
The European Central Bank
Ever since the GFC, there has been a worldwide collapse in confidence levels and global demands. This, combined with the sovereign debt crisis, has left several EU member states, for example, Greece, Portugal, Ireland, Spain, and Cyprus, imposing fiscal austerity. From this, the EU saw even tighter financial conditions and a sharp decline in economic activity, implying little room for fiscal stimulus. In response, the ECB lowered one of its key interest rates into negative territory in June 2014. The process was a gradual one, where the deposit facility rate (DFR) was lowered in small increments of 10 basis points, until it reached -0.5% in September 2019.
The ECB’s NIRP narrative is mainly a story of banking. As was addressed in the section on Sweden, a key point is the transmission of negative rates. For Sweden, transmission was particularly inhibited in the pension industry, but for Europe more generally, any retail deposit resists negative rates due to similar legislative hurdles and concerns about deposit withdrawals. Data on the volume of overnight deposits held by households in the euro area confirms the negligible pass-through of negative policy rates to banks’ retail deposit rates (Figure 3). On the other hand, banks more frequently charge negative rates on deposits held by non-financial corporations (NFCs) (Figure 4). Within the euro area, this primarily applies to Germany, Luxembourg and the Netherlands. This induces firms to decrease their cash holdings through investments, thus supporting the standard monetary policy transmission mechanism (Abildgen & Kuchler, 2020).
Loan growth also flourished from the ECB’s NIRP. Negative rates lower borrowing costs, leading to an increase in demand for loans (Figure 5). These findings are corroborated by an ECB meta-analysis of various studies.
The key debate on the effects of NIRP on the banking sector is the overall effect on banking profitability. Given that there is statistical evidence supporting both sides, the overall effect is currently deemed ambiguous.
Indeed, there are channels where NIRP can support bank profits, through its impact on loan growth as shown above. Moreover, assuming NIRP is an expansionary tool on aggregate, NIRP stimulates the economy to improve macroeconomic conditions, resulting in higher intermediation volumes and increased borrower creditworthiness, both supporting net interest income.
On the contrary, negative rates hurt bank profits by taxing their excess reserves and squeezing their net interest margin, which accounts for 60% of the banking industry’s revenue in Europe (IMF, 2016). Admittedly, higher aggregate demand and asset quality did help to raise investment income and lower provision expenses, which mitigated the adverse impact on banking profitability in the euro area to a certain extent. However, these benefits have weakened over time, especially in countries where the pass-through of policy rates is high and low credit demand limits the extent to which banks increase lending to offset the impact of lower lending rates (IMF, 2016).
Certain negative impacts may at some point outweigh the benefits from higher asset values and stronger aggregate demand. Further monetary accommodation may need to rely more on credit easing and an expansion of the ECB’s balance sheet rather than substantial additional reductions in the policy rate. The bottom line is that it is too early to decipher the overall impact of NIRP on banking profitability, something that the BoE should be very wary of.
The Bank of Japan
Japan’s economic stagnation can be traced back to the 1990s; the “lost decade” witnessed potential growth rates dropping from 4% to 1% at the end of the 1990s. To stimulate economic activity, the Bank of Japan lowered the policy interest rate from 6% in the early 1990s to 0.5% by 1995. “Japan’s trap” (Kurgman, 2000) brings the concept of a liquidity trap, which we had only seen in textbooks, to reality. Despite persistent efforts to combat economic slowdowns, such as a zero-interest rate (1999) and quantitative easing (2001), deflation appeared to be more stubborn than expected.
Haruhiko Kuroda, governor of the Bank of Japan, believes the root cause of economic stagnation was the decline in the natural rate of interest (as described by Vlieghe in the introduction) combined with falling inflation expectations. These challenges made it difficult to lower the short-term interest rate further as an expansionary tool, leading to further decline in price levels. After the GFC, while Europe, the USA, and the UK had very little room to cut short-term interest rates to boost economic activities, Japan had even less space given the problem of falling inflation expectations. More attempts were made to bring Japan out of this stagnant curve. In 2013, the Bank of Japan announced a clear commitment to achieving a well-anchored inflation expectation target at 2%. Additionally, the Bank purchased long-term government bonds to lower the long-term interest rate. Finally, Japan welcomed its long-awaited rise in inflation expectations. There seemed to be no more deflation; however, a stable price level at 2% was far beyond reach. Investors remained at a low level of optimism and were extremely sensitive to any observed inflation rate decline, even if the decline was only temporary.
In January 2016, the Bank of Japan followed Sweden and the ECB’s direction by introducing a NIRP in hopes of pushing down interest rates across the entire yield curve and guiding expectations. However, this attempt appeared to be counterproductive as household inflation expectations fell further. The reasons for this are still being debated; understanding the reasons is critical to understand if the UK should fear a similar unintended consequence.
Glover (2019) argues that an expectation-driven liquidity trap caused Japan’s deflation, and in such an environment, NIRP could be counterproductive to the Japanese economy. Under a prolonged deflation environment, it was probably unsurprising to view NIRP as a response to predicted future deterioration in the Japanese economy. This spurred fears among Japanese citizens, causing many to increase their already high savings as a precaution. Higher savings corresponded to less immediate economic expansion, pushing inflation down even further. In other words, NIRP might have been a false policy response causing further deflation instead of the desired inflation in Japan.
In contrast, advocates of NIRP believe that the fall in expectations was associated with the deterioration of market activities. That is, inflation expectations fell because of deteriorating economic performances, and expectations would have dropped even further had the Bank not introduced NIRP.
The BoE’s decision to implement NIRP therefore depends partly on which of the causes of Japan’s deflation they believe, which again adds to the caution that the BoE should observe. If they believe in Japan’s expectation-driven liquidity trap; their population’s inflation expectations are unanchored; and their population is pessimistic of the future of the UK’s economy, then they should not implement NIRP.
Implications for the UK
Let us summarise our findings from Sweden, Europe, and Japan. NIRP is unambiguously ineffective for an already expanding economy (as demonstrated by Sweden) or for an economy in an expectation-driven liquidity trap (as demonstrated by Japan). The COVID-19 pandemic has brought about one of the deepest recessions of modern times, with output at times below the trough of 2008. Fortunately, the UK’s inflation expectations are well-anchored through the work of effective central bank communications. Additionally, optimism among UK citizens is building as the vaccine roll-out and reopening of the economy has been so far somewhat successful. Therefore, we may ignore the lessons from Sweden’s overheating and Japan’s liquidity trap in our analysis. What remains are the hotly debated effects of NIRP on the financial sector (as demonstrated by Europe).
We need to deduce how strong the external validity problem is when comparing the UK and Europe’s financial sectors. Some economists argue that the UK’s banking sector would be left particularly vulnerable from NIRP given that the UK has had an increased reliance on retail deposits post-GFC, and as we saw in the sections on Sweden and Europe, banks with many retail deposits are most at risk from NIRP (De Groot & Haas, 2020).
What does the Bank of England have to say? At the recent society event, when asked for his opinion on if the UK might go negative in response to COVID-19, or in the future more generally, Vlieghe replied:
“I have talked about me being open to the idea. Currently, the economic outlook does not require it. But if we have persistent disappointments, we might have to go there. So, the question depends critically on the strength of this recovery. Whether it goes, whether it lasts. We will have to see.”
Since then, inflation in the UK has risen and the Bank of England raised interest rates in response. The debate over the use of NIRP in response to COVID-19 seems to be over given the strength of the UK’s recovery. But what about as a future policy tool?
In 20 years from now, central bankers and macroeconomists will hope to have learnt a great deal about negative interest rates. We already know that their use on an already expanding economy, or on an economy in a liquidity trap, can be dangerous. We also know that their effectiveness depends critically on the ability of negative rates to transmission from the central bank, through the banking sector, to the general public. Once we understand the specific conditions under which NIRP is most effective in stimulating the economy by conducting analyses like this one with future case studies, NIRP could well become a standard tool in all central banks’ monetary toolkits.
This article was written by: Joe Marshall (Former Research Associate, Economic Research), Kelly Ding (Former Research Associate, Economic Research) and Sarah Wang (Former Research Associate, Economic Research). This article was reviewed by Joe Marshall (Current Head of Economic Research).
 Follow the link here to see the recording of the LSESU Central Banking Society Event with Dr Gertjan Vlieghe.
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