Haruhiko Kuroda, Governor of the Bank of Japan
In late January, the Bank of Japan jolted financial markets when it announced that it would begin charging private banks to hold their reserve funds. By lowering its deposit rate on excess reserves to -0.1 percent, the Bank of Japan (BOJ) joined many European central banks in implementing a negative interest rate policy (NIRP) to combat deflation. NIRPs contradict the financial axiom that lenders should be compensated for lending, and in doing so they challenge the foundations of the modern financial system. In light of these implications and the growing prevalence of NIRPs among central banks, it is essential to examine NIRPs and evaluate their validity as a monetary policy measure. Unfortunately, careful analysis of NIRPs suggests that they may actually hinder financial stability and economic growth.
In the aftermath of the 2008 financial crisis, many developed countries struggled with deflation, economic contraction, and financial instability. Central banks including the US Federal Reserve, the European Central Bank (ECB), and the BOJ adopted innovative policy measures to mitigate these stresses. However, in Europe and Japan, years of near-zero interest rates and expansive quantitative easing programs have not been adequate to spur inflation and production. European and Japanese central bankers have thus come to the conclusion that additional monetary accommodation is needed to support recovery. The BOJ, the ECB, and the central banks of Sweden, Denmark, and Switzerland have adopted NIRPs to this end.
Negative Rate Theory
The theoretical basis for NIRPs is fairly simple. By lowering deposit rates below the zero bound, central banks can charge private banks for saving excess reserves. This incentivizes lending over saving and encourages the consumption necessary for growth and inflation. The expansion of the money supply associated with this lending also promotes currency depreciation, providing a boon to domestic exporters. In this sense, NIRPs are essentially an extension of conventional interest rate policy: Lower benchmark rates ease credit conditions and stimulate investment, production, and price growth. Furthermore, implementation of NIRPs demonstrates central banks’ resolve to fight deflation. This effort to maintain central bank credibility should instill confidence in investors and benefit financial stability.
According to this theoretical framework, NIRPs should prove a viable monetary policy tool to combat deflation and contain associated contractionary pressures. However, negative interest rates may also have adverse economic effects relating to banks and financial markets. Consideration of these factors suggests that NIRPs are, at best, an ineffective way to promote inflation. At worst, they may impair world economies and financial systems.
The Negatives of Negative Rates
The most troubling problem with NIRPs involves their effects on banks. Banks serve as crucial intermediaries between lenders and borrowers, facilitating investment by loaning out the funds of depositors, shareholders, and creditors. In a normal interest rate environment, a bank charges borrowers higher interest rates than it pays to acquire loanable funds. The spread between the average interest rate charged and the average interest rate paid constitutes the bank’s net interest margin and is the bank’s primary source of profit. Central bank interest rates serve as benchmarks for the rates charged on loans, so there is a positive relationship between central bank rates and net interest margins. As central bank rates rise, interest rates on loans typically increase faster than banks’ costs of funds, and net interest margins increase. Conversely, falling central bank rates squeeze net interest margins as loan rates and banks’ costs of funds fall toward zero. In the extreme case, NIRPs could produce near-zero or negative net interest margins as the rates charged on loans and other assets approach negative territory.
This threat to bank profitability has severe implications for the global economy. In order to cope with near-zero or negative net interest margins, banks would be forced to halt unprofitable lending operations and pass additional costs onto depositors, shareholders, and creditors. Tightening monetary conditions and financial system instability would likely ensue, contrary to central banks’ goals of easing monetary conditions and encouraging stability. In this manner, NIRPs could actually exacerbate deflationary and contractionary pressures instead of alleviating them.
Unfortunately, the painful effects of NIRPs extend beyond banks to global financial markets. Low central bank rates drag down yields on sovereign bonds, and in an environment with negative interest rates and expectations of deflation, bond yields can turn negative. By some estimates, nearly 30 percent of developed government bonds are now negative-yielding due to falling interest rates in Europe and Japan. This development highlights the dangerous market distortions caused by NIRPs. Investors are essentially paying to lend governments money, a bewildering phenomenon that disrupts market allocation of credit and hurts private investors. Large banks and other firms that purchase sovereign debt again suffer, and general financial stability is impaired by unusual market conditions.
Perhaps the most compelling indictment of NIRPs is that they are simply ineffective. Since their central banks began implementing NIRPs after the financial crisis, the Eurozone, Sweden, Denmark, and Switzerland have seen prices stagnate or fall. GDP growth has accelerated modestly, though struggling financial firms in Europe and the United States have contributed to market volatility and renewed concerns about the health of the global financial system. Indeed, there is little reason to expect that the BOJ’s move toward negative rates will significantly bolster inflation or growth. On the contrary, the new NIRP indicates the BOJ’s lack of confidence in the Japanese economy and suggests continued difficulties with deflation and contraction.
Monetary Policy: Not a Panacea
To a significant extent, the recent trend toward negative central bank interest rates is a manifestation of a larger misconception about monetary policy. Many investors and economists have been lulled by the notion that central bankers can correct market dysfunction and stimulate persistent growth using innovative and well orchestrated policies. Although monetary policy does offer a potent means to mitigate short-term swings in the business cycle, it is not a cure-all. Shifts in inflation and growth due to monetary policy are transitory, and central banks are simply not equipped to guide market economies with precision. With the advent of NIRPs in addition to unprecedented asset purchase programs, it appears that central bankers have also forgotten the limitations of monetary policy. In the words of John Maynard Keynes, central banks are now “pushing on a string” by seeking monetary solutions to broad economic problems. Additional stimulus is unlikely to benefit economies still shaken by the memory of the Great Recession. In the case of NIRPs, further “accommodation” may actually undermine recovery.
Todd Lensman is a freshman in the College of Arts & Sciences at Cornell University, majoring in Mathematics and Economics.