The European Central Bank (ECB) and the Bank of Japan (BoJ) are expected to cut rates further into negative territory, which may prompt other central banks to follow them lower in order to maintain the competitiveness of their currencies, QNB has said in a report.
In response to the global financial crisis of 2008 and its aftermath, central banks around the world have implemented ever easier monetary policy. Initially, a number of central banks cut policy rates close to zero, bringing down short-term interest rates.
“Believing that policy rates could not go significantly negative, central banks began to turn to alternative unconventional means of easing monetary policy,” QNB said in a report yesterday.
Chief among these was quantitative easing—the purchase of government bonds, which helped lower long-term yields. With long-term interest rates now at historical lows, the impact of quantitative easing may have lessened. Since 2014, this has led a number of central banks, to start exploring negative policy rates. As it turns out, central banks may be able to cut their policy rates further below zero than previously thought.
Negative interest rates mean that banks are effectively charged to keep excess reserves at central banks They are imposed to encourage lending to the economy and discourage saving. It was thought that central banks would be unable to cut rates much below zero for two main reasons.
First, negative interest rates could encourage banks, individuals or companies to hoard cash. If there is a charge for depositing money in the banking system or at the central bank, then it would make sense to switch to cash, which always has an interest rate of zero—one does not receive or pay any interest for holding a banknote.
Second, negative interest rates could hurt banks’ profitability. If banks do not pass on negative interest rates to customers, then they will not be compensated for the losses they are incurring on their reserves at central banks, which face negative rates.
However, despite these limitations, a number of central banks have lowered rates into negative territory without inducing a collapse in their banking system or sparking an exodus from bank deposits into cash. How did they manage to do this?
First, it turns out that the cost of negative central bank rates can actually be relatively low. For example, in Switzerland, where rates are currently -0.75%, JP Morgan estimates that the cost of negative interest rates to banks is 0.03% of their total assets.
There has been no dash to cash in Switzerland, suggesting that this level of interest costs on deposits is tolerable for banks.
Second, to discourage a switch into cash, both the Swiss National Bank and the Bank of Japan (BoJ) have introduced penalties for banks that hold a high proportion of cash as reserves.
Finally, central banks have been innovative in their implementation of negative interest rates.
For example, when the BoJ surprised markets by cutting rates to -0.1% in January, it also introduced a tiered system of reserves, so that the negative interest rate was only applicable to a portion of bank reserves.
A tiered reserve system has also been put in place in Switzerland and Denmark. This helps to reduce the costs of negative interest rates for banks.
The negative rate experiment suggests that the interest rate lower bound is not zero, but probably lower. In fact, some central banks may be able to go significantly lower. This provides additional room for central banks to cut rates to ease monetary policy further.
However, there are concerns that cutting rates deeper into negative territory may not be as effective as cutting rates when they are above zero. This is because banks are reluctant to pass on negative deposit rates to corporate and retail customers in the real economy.
This means the central bank’s rate cut is only partially transmitted to the rest of the economy, limiting its impact on growth and inflation.
QNB said it has become evident that central banks have the potential to cut rates much further below zero than previously thought.
The question remains whether they want to do this, given the weaker pass through from banks to their customers, and the negative impact on bank profits. However, central banks may see these costs as worth paying in order to boost growth and raise inflation.