Impact of negative interest rates: Living in the unknown Global Economic Outlook, Q2 2016

Imagine a lender paying interest to a borrower instead of the other way round—which is precisely what’s happening in Europe and Japan. Negative interest rates join the long list of central banks’ unorthodox policies to counter deflation and revive economic growth—but have they been successful?


It seems strange when a lender pays interest to a borrower instead of the other way round—but that’s precisely what is happening in parts of Europe and Japan. In June 2014, the European Central Bank (ECB) cut the interest rate on its deposit facility to below zero. Three further cuts followed, the latest one in March 2016 (to -0.4 percent). Central banks in Switzerland, Sweden, and Denmark have also pushed interest rates into negative territory. Then in January 2016, the Bank of Japan (BOJ) joined the chorus, unexpectedly announcing that it would charge banks for excess reserves.

Negative interest rates join the long list of unorthodox policies by central banks to counter deflation and revive economic growth. The question is, have negative interest rates been successful? Data from the Eurozone suggest that the ECB scored some initial successes. But, with banks, households, and businesses still recovering from the global financial crisis and the sovereign debt crisis, gains for the ECB have been limited. In Japan, it’s a bit early to take a call. The confusion surrounding the subzero rate cut, however, does not augur well for the BOJ’s long fight against deflation.

Why are central banks defying convention to cut policy rates below zero?

The need to counter deflation

With inflation still below the respective targets of the ECB and BOJ, and downward pressure on inflation expectations, both central banks have taken recourse to unorthodox policies. First came quantitative easing (QE) and then negative interest rates. Central banks are hoping that as interest rates fall below zero, banks will reduce their excess reserves and lend more. The resultant rise in liquidity and aggregated demand will push prices up. The ECB and BOJ are also concerned that low inflation, or deflation, could raise real interest rates. Negative interest rates, they believe, will stem any rise in real rates. (See the sidebars “Understanding the real and nominal aspects of interest rates” and “How negative policy rates can boost credit growth” to better understand these phenomena.)

Checking capital inflows and preventing currency appreciation

The BOJ has made no bones about its desire to weaken the Japanese yen to boost exports. Negative interest rates appear to be yet another gambit after strong QE pushed the yen lower in 2013 and 2014. Eurozone exports also have benefitted from a weaker euro. A depreciating currency props up import prices, thereby helping to fight deflation. Sweden, Denmark, and Switzerland opted for negative interest rates to prevent sharp capital inflows due to interest rate differentials with the Eurozone. Rising inflow, especially during the Eurozone sovereign debt crisis, led to sharp currency appreciation in these countries, denting their export competitiveness.

Understanding the real and nominal aspects of interest rates

Negative interest rates imply that in the process of borrowing and lending, lenders pay interest while borrowers receive it, the opposite of what normally happens. Wouldn’t a lender prefer to hold onto funds rather than pay the borrower? Indeed, from that argument, it would be rational to assume that interest rates have a zero lower bound. In reality, interest rates do turn negative—but we have been talking about real interest rates and not nominal interest rates so far. The real interest rate is defined as the nominal interest rate adjusted for inflation as shown in the equation below:

If inflation is higher than the nominal interest rate, the real rate goes below zero. In such a scenario, borrowers benefit at the expense of lenders because, despite paying nominal interest, the borrower’s purchasing power increases (figure 1).
Figure 1

In recent times, however, it is the nominal interest rate that has turned negative. Central banks such as the ECB and the BOJ have started charging interest on commercial banks’ excess reserves. The zero lower bound for nominal interest rates appears to have been breached.

How negative policy rates can boost credit growth

Central banks pay interest on the excess reserves—those above the minimum level required—of commercial banks. Normally, banks prefer not to hold reserves in excess of the minimum requirement because the interest rates offered by central banks are lower than money market rates. However, when financial risks rise and money market rates are low, most commercial banks choose to hold higher reserves with the central banks. This often results in a credit freeze. The thinking behind negative interest rates on excess reserves is that banks will likely be forced to cut down on excess reserves and lend instead of incurring costs. This, in turn, will likely boost domestic demand.

Negative interest rates have yielded mixed results

Inflation has not been impacted much by negative interest in the Eurozone

Since June 2014, when the ECB first cut interest rates below zero, inflation hasn’t gone up. In February 2016, inflation was -0.2 percent, lower than what it was in June 2014 (0.5 percent). While low energy prices have weighed on consumer prices, a look at core inflation indicates that negative interest rates have not helped much either in the fight against deflation (figure 2). In Japan, it is too early to assess the impact of negative interest rates on inflation. Current trends, however, indicate that despite QE since 2010, the BOJ has so far not been successful in propping up prices.

Figure 2

In Japan, it is too early to assess the impact of negative interest rates on inflation. Current trends, however, indicate that despite QE since 2010, the BOJ has so far not been successful in propping up prices.

Moderate impact on credit growth so far

QE and negative interest rates have aided credit growth in the Eurozone. Credit to both households and nonfinancial corporations has picked up since the second half of 2015 (figure 3). However, growth is much slower than before the global financial crisis. Also, there is a clear divergence in the Eurozone, with troubled economies such as Spain and Italy faring worse than Germany (figure 4). In Japan, the BOJ has been able to revive credit growth from negative territory using QE. But with the pace of growth still slow, it is evident that, without strong demand, low borrowing costs alone will not help.

Figure 3

Figure 4

Despite low borrowing costs, households are not going on a credit binge

In the Eurozone, households appear wary of borrowing given a weak labor market and slow wage gains (figure 5). For example, unemployment was 10.3 percent in January 2016; the rate was higher than the average in Italy, Spain, Greece, and Portugal.1 In this scenario, households are more intent on repairing their balance sheets. For example, despite easy monetary policy for the last five years, household debt as a share of disposable personal income has gone down, albeit marginally.2 In Japan as well, households are unlikely to raise credit-fueled spending soon, even if lending rates go down further due to negative interest rates.

Figure 5

With demand weak, businesses are not increasing spending

For businesses, borrowing and investment options are restricted by low domestic demand growth. In the Eurozone, although domestic demand growth has been recovering since Q1 2014, it has been volatile (between 0 and 0.8 percent). The same is true for Japan, where businesses are holding onto spending decisions in the absence of strong domestic and foreign demand (figure 6).

Figure 6

Also, as currency depreciation stalls, lately export competitiveness has been hit (figure 7). Investors are flocking to the yen in particular, searching for a safe asset amid global uncertainty. Between January 29 (when the BOJ introduced negative interest rates) and March 22, 2016, the yen gained 8.3 percent against the US dollar.

Figure 7

In the Eurozone, a weak banking sector has not helped

For negative interest rates to make an impact, the banking system’s response is critical. Unfortunately, banks are under pressure in the Eurozone due to slow asset growth, economic uncertainty, and rising nonperforming assets. Negative interest rates have added to their discomfort by denting banks’ interest income. For example, net interest income as a share of banks’ total income fell to 58.7 percent in 2014 from 67.6 percent in 2008.3 Bank valuations have suffered as a result (figure 8).

Figure 8

Some troubling trends have emerged

Reserves are on the rise in the Eurozone despite negative interest rates

For the ECB, a big worry is that banks have been increasing their excess reserves. This defeats the very purpose of negative interest rates. Between June 2014 and January 2016, excess reserves shot up more than 400 percent (figure 9). This shows that banks in the Eurozone still prefer to park extra funds and pay the ECB rather than lending in the current environment of market uncertainty and subdued economic growth. Cross-border lending, which would have helped, has been hit due to differential risks within the Eurozone and cautious national regulators.4

Figure 9

For the ECB, a big worry is that banks have been increasing their excess reserves. This defeats the very purpose of negative interest rates.

There’s a floor to lending and deposit rates

Although negative policy rates have lowered banks’ lending and deposit rates, there is a limit to which both can fall. For example, after the ECB cut rates to -0.3 percent in December 2015, the cost of borrowing for nonfinancial corporations and households was unchanged.5 Deposit rates are also at an all-time low (figure 10). Banks will be reluctant to cut rates further because it might force people to keep cash at home instead of putting it in a bank.6

Figure 10

If negative rates don’t push up inflation, real yields will rise

With nominal interest rates below zero, real rates will rise if inflation does not pick up. In February 2016, the real yield on 10-year Eurozone bonds was higher than the nominal yield (figure 11). In Japan, real yields for 10-year sovereign bonds are back in positive territory. As governments are saddled with high debt, any sustained rise in real yields will be worrying.

Figure 11

Negative interest rates have hit money markets in Japan

In Japan, negative interest rates are denting money market liquidity as market participants struggle to cope with negative rates. In February 2016, for example, the average amount outstanding in money markets (uncollateralized) fell by a staggering 39.5 percent (figure 12). This is primarily due to the unexpected nature of the rate cut (below zero) in January.7

Figure 12

The worry is that with interest rates negative, the ECB and the BOJ are left with fewer policy tools to counter any new headwinds. Surely, central banks cannot push rates below zero much further.

Yearning for a return to normal?

In the Eurozone, equity markets cheered the first two rate cuts (below zero) but were more muted in response to the third and the fourth (figure 13). In Japan, while markets reacted positively on January 29, the euphoria was short-lived, with businesses and policymakers still trying to make sense of the BOJ’s latest policy decision.8 In fact, there is a debate within the BOJ itself on whether to carry on with negative interest rates.9

Figure 4

The worry is that with interest rates negative, the ECB and the BOJ are left with fewer policy tools to counter any new headwinds. Surely, central banks cannot push rates below zero much further. In the Eurozone, monetary policy alone, without structural reforms and coordinated fiscal policy, cannot tackle challenges in a diverse region. Negative interest rates also add to the confusion in global financial markets due to a wide swathe of unorthodox monetary policies across the world since 2008. It’s no surprise, then, that economists and policymakers are increasingly calling for an end to such policies and a return to more transparent policy coordination.10 It might be worth heeding that call.