STUDY Requested by the ECON committee Monetar y Dialogue Papers, June 2021 Low for Long: Side Effects of Negative Interest Rates Policy Department for Economic, Scientific and Quality of Life Policies Directorate-General for Internal Policies Authors: Justus INHOFFEN, 3Atanas PEKANOV, Thomas URL PE 662.920EN PE 662.920 - June 2021 Low for Long: Side Effects of Negative Interest Rates Monetary Dialogue Papers June 2021 Abstract Policy rate cuts in negative territory have increased credit supply and improved the macroeconomic environment similar to cuts in positive territory. Dreaded disruptions to the monetary policy transmission channels as well as adverse side effects on bank profitability have so far largely failed to materialise. Thus, the evidence available today shows that the negative interest rate policy is an effective policy tool. However, systemic risks, including in the non-bank sector, should be closely monitored as negative rates are expected to remain low for longer. This paper was provided by the Policy Department for Economic, Scientific and Quality of Life Policies at the request of the committee on Economic and Monetary Affairs (ECON) ahead of the Monetary Dialogue with the ECB President on 21 June 2021. This document was requested by the European Parliament's committee on Economic and Monetary Affairs (ECON). AUTHORS Justus INHOFFEN, German Institute for Economic Research Atanas PEKANOV, Austrian Institute of Economic Research Thomas URL, Austrian Institute of Economic Research ADMINISTRATOR RESPONSIBLE Drazen RAKIC EDITORIAL ASSISTANT Janetta CUJKOVA LINGUISTIC VERSIONS Original: EN ABOUT THE EDITOR Policy departments provide in-house and external expertise to support European Parliament committees and other parliamentary bodies in shaping legislation and exercising democratic scrutiny over EU internal policies. To contact the Policy Department or to subscribe for email alert updates, please write to: Policy Department for Economic, Scientific and Quality of Life Policies European Parliament L-2929 - Luxembourg Email: [email protected] Manuscript completed: June 2021 Date of publication: June 2021 © European Union, 2021 This document was prepared as part of a series on “Low for Longer: Effects of Prolonged Negative Interest Rates”, available on the internet at: https://www.europarl.europa.eu/committees/en/econ/econ-policies/monetary-dialogue Follow the Monetary Expert Panel on Twitter: @EP_Monetary DISCLAIMER AND COPYRIGHT The opinions expressed in this document are the sole responsibility of the authors and do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorised, provided the source is acknowledged and the European Parliament is given prior notice and sent a copy. For citation purposes, the publication should be referenced as: Inhoffen, J., Pekanov, A., Url, T., Low for Long: Side Effects of Negative Interest Rates, Publication for the committee on Economic and Monetary Affairs, Policy Department for Economic, Scientific and Quality of Life Policies, European Parliament, Luxembourg, 2021. Low for Long: Side Effects of Negative Interest Rates CONTENTS LIST OF FIGURES 4 LIST OF TABLES 4 LIST OF ABBREVIATIONS 5 EXECUTIVE SUMMARY 6 INTRODUCTION 8 THE NATURAL RATE OF INTEREST 10 NEGATIVE INTEREST RATES EFFECTIVELY EASED FINANCIAL CONDITIONS 14 3.1. Monetary policy transmission 14 3.2. The reversal interest rate 17 ADVERSE SIDE EFFECTS OF NEGATIVE INTEREST RATES 22 4.1. On bank profitability 22 4.2. On non-bank intermediaries 22 4.3. On asset price inflation in the real estate sector 24 4.4. On productivity growth 27 CONCLUSION 29 REFERENCES 31 3 PE 662.920 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies LIST OF FIGURES Figure 1: Developments in policy rates and bank lending rates 8 Figure 2: Holston-Laubach and Williams estimates of the natural interest rate 12 Figure 3: Long term government bond yields 12 Figure 4: Effects of NIRP on sovereign bond yields 15 Figure 5: Loan growth of euro area commercial banks 15 Figure 6: Deposit interest rates paid by commercial banks in the euro area 16 Figure 7: Development of the currency in circulation and M3 in the euro area 19 Figure 8: Stylised bank balance sheet 20 Figure 9: The relation between interest rates and real estate prices from 2000-2020 25 LIST OF TABLES Table 1: Interest rates on new deposits from households and non-financial corporations, March 2021 18 Table 2: Estimated effects of a plus one percentage point monetary policy shock after two years26 PE 662.920 4 Low for Long: Side Effects of Negative Interest Rates LIST OF ABBREVIATIONS APP Asset purchase programme CMP Conventional monetary policy DFR Deposit facility rate DSGE Dynamic stochastic general equilibrium ECB European Central Bank ESCB European System of Central Banks EU European Union MFI Monetary financial institutions NIM Net interest rate margins NIRP Negative interest rate policy NMFI Non-monetary financial institutions TFP Total factor productivity TLTRO Targeted longer-term refinancing operations UMP Unconventional monetary policy VAR Vector autoregression 5 PE 662.920 IPOL | Policy Department for Economic, Scientific and Quality of Life Policies EXECUTIVE SUMMARY • Negative interest rate policies (NIRPs) have been introduced in a number of advanced economies in recent years as central banks have aimed at addressing the low inflation environment with unconventional monetary policy tools. The entry into negative territory raised several concerns about its effects on the transmission of monetary policy and possible side effects. • The decade-long decline in the natural rate of interest suggests that a low interest rate environment may be here to stay for a prolonged period in advanced economies. This trend may necessitate the more often usage of NIRP after significant macroeconomic shocks. • Policy rate cuts in negative territory have successfully eased financial conditions in largely similar ways as standard interest rate cuts. The interest rate channel of transmission was effective as evidenced by prevalent money market rates and a downward shift of the government bond yield curve. Market participants’ expectations of future short-term interest rates were successfully steered towards negative territory. The credit channel effectively raised credit growth to households and the non-financial sector. • Concerns of a muted policy rate pass-through towards bank clients only partly realised. Banks were expected not to charge negative rates from clients, which could disrupt policy transmission and severely impact profitability. While this did occur for deposit rates of households, it did not for non-financial corporates. Causal evidence of the negative effect on credit supply for banks most reliant on deposits and consequently most exposed to NIRP is inconclusive. • There are several systemic risks associated with NIRP: it may reduce bank profitability by eroding the interest rate income of banks, may create asset price bubbles, or hurt the yield on pension savings. In search for yield, banks can lend to riskier counterparties, invest in riskier assets, and thereby endanger financial stability. • Evidence suggests that banks prevented severe adverse effects on their profitability by modifying their business strategies and have benefited from other factors not guaranteed to persist in the long run. Empirical evidence suggests that clients did not significantly withdraw their deposits which would endanger bank funding. Further, banks realised gains on their fixed income assets, against which they could also borrow more on wholesale markets, and decrease their loan loss provisions. • While the impact of monetary policy rates on real estate prices is an important transmission channel, housing is also a crucial part of households’ wealth and consumption spending. From a consumer perspective, asset price inflation affects the decision to acquire home ownership and rental rates. International evidence suggests that a one percentage point decrease in the interest rate will cause an increase in real estate prices of 6% to 8% over the following three years. • NIRP may adversely affect non-monetary financial intermediaries (NFMI). A protracted low interest rate will hit the solvency status of NMFIs and plan sponsors depending on the extent to which they guaranteed minimum returns. NMFIs may implement riskier strategies to meet their obligations. Beneficiaries of non-guaranteed pension products will have to bear the low return on assets. Due to limited available data, there is little evidence on effects on NFMIs. • The evidence points towards cautious optimism regarding NIRP as a monetary policy instrument. So far, it cannot be associated with significant adverse effects. The empirical assessment suggests that it has delivered on its objectives and has worked similarly to standard PE 662.920 6 Low for Long: Side Effects of Negative Interest Rates nominal interest rate cuts. The main adverse effects of NIRP, i.e. the disruption of monetary policy transmission as well as financial fragility arising from low bank profitability and an excessive pressure for cash hoarding, have not yet materialised in the euro area. • Ongoing assessment is needed to understand whether market participants can continue to cope with the pressure on profitability in negative territory when policy rates decrease further and/or remain on this level for years to come. In the face of considerable