The logic and limits of negative interest rate policy

Negative interest rate policy, as an aspect of monetary easing by central banks, is an odd thing. How can an interest rate be negative? Doesn’t that mean the lender gets back less than it lends, seemingly violating the economic truism that there is a (positive) time value of money?

Indeed, it does, which is why negative interest rates really only exist in the world of central banks. Central banks usually operate monetary policy by setting a target interest rate in the overnight market in which financial institutions borrow and lend central bank reserves or deposits among themselves. Because the central bank, by increasing or decreasing its assets, can control the total amount of reserves (a liability on its balance sheet), it can also set the price (interest rate) attached to those reserves.

Not much in the economy depends directly on the overnight interest rate in the inter-bank market. But the entire term structure of interest rates, which does influence lending and borrowing decisions in the real economy via arbitrage, takes its cue off this rate. By influencing the public’s expectations of the future path of the overnight rate, central banks can influence economic activity.

Pre-crisis, central banks such as the Federal Reserve or the Bank of England set a positive interest rate and adjusted reserves to be just in line with minimum reserve requirements (which they also set). Then, after the crisis, many central banks, after cutting their policy rate to or close to zero, started to expand their balance sheets, creating large amounts of excess reserves (quantitative easing or QE).

It is but a short step from there for the central bank to apply a negative interest rate to the reserves it creates, as the Bank of Japan (since January 2016), the ECB (since June 2014), and several other European central banks have done.

Negative interest rate policy is a simple extension of “regular” monetary easing: another way—alongside cuts in the policy rate in positive territory, “forward guidance” about the intended future path of the policy rate, and quantitative easing—to exert downward pressure on the term structure of interest rates in order to ease financial and financing conditions and thereby buoy economic activity.

It is not obvious, without a little thought, that the central bank’s negative interest rate on all or part of the liabilities it requires financial institutions in aggregate to hold will exert any more downward pressure on the yield curve than setting a zero interest rate would. It might be thought that the time value of money—the fact that lenders who engage in voluntary exchange will not lend at a negative rate—would make zero the anchor rate for influencing the yield curve. A negative policy rate then would just be a tax on financial institutions, with no incremental monetary easing benefits. The fact that it took so long for central banks to start to use negative interest rate policy suggests this is probably what they believed.

But it appears that a negative policy rate does put more downward pressure on longer term interest rates than a zero rate. This can be explained by thinking about the implications for asset market equilibrium: the set of asset prices in the economy that eliminates arbitrage opportunities.

Although financial institutions in aggregate must hold the total amount of reserves the central bank decides to create, the asset market equilibrium associated with a negative interest rate being applied to those reserves will differ from the one associated with a zero interest rate (or a positive rate).

Take a 10-year government bond, for instance, and assume the policy rate is zero. In equilibrium, by definition, a financial institution holding that bond has to be indifferent between continuing to hold that bond and selling it to the central bank and receiving a deposit at the central bank in exchange. If the central bank now sets a negative interest rate on reserves, holding reserves becomes less attractive than before and holding 10-year bonds will have to become a little less attractive too—that is, bond prices will have to rise or yields fall—in order for asset market equilibrium to be restored. This yield-curve-depressing effect of negative interest rate policy has been so successful that in several countries long-term bond yields out to 10 years or more have been pushed into negative territory.

A commonly-heard criticism of negative interest rate policy is that it represents a “tax” on banks and crimps bank profit margins. The possible result could be counterproductive, leading banks to lend less, not more.

These arguments seem suspect. True, central banks could force banks to hold a very large amount of reserves and could impose a large negative interest rate on those reserves. Given that the zero bound is more binding on the liability side of the banking system’s balance sheet than the asset side, in competitive equilibrium banks might need to raise lending rates in order to earn a normal rate of return in such a situation.

But, as the BOJ has shown, in order to push down the yield curve, central banks need only impose a negative interest rate on the marginal reserves they are creating. The “tax” imposed is minimal and, with lower funding costs for banks and lowers borrowing costs for borrowers, the amount of bank lending generated over time is likely to be higher than it otherwise would be.

My criticisms of negative interest rate policy are different and two-fold.

First, negative interest rate policy may be too complicated and counter-intuitive to be worth the trouble. The efficacy of monetary policy rests largely on the central bank being willing and able to communicate clearly and effectively with the public. The Alice in Wonderland nature of the concept of negative interest rates, and the complicated nature of the schemes for implementing it, seem to be at odds with the canonical principles of modern central banking: keep things as simple and transparent as possible.

But, more to the point, if central banks need to resort to such a controversial, complicated and counter-intuitive tool as negative interest rate policy, this long after the Global Financial Crisis and the Great Recession, doesn’t this argue for fiscal policy to be mobilized much more actively to try to restore economies to full employment as quickly as possible? The more central banks venture into new uncharted monetary waters, the more compelling the case for expansionary fiscal policy becomes.

Paul Sheard, PhD – Executive Vice President, Chief Economist – S&P Global