How low can you go?
Central bankers are rushing to offer policy support as the global economic outlook darkens. However, there are concerns that policy is reaching a ‘reversal rate’ at which loosening does more harm than good. Does such a concept exist, and, if so, where does it sit?
Reversal rates could work through a number of channels. Historically, there have been concerns that a move into negative rates would prompt deposit flight from banks. However, there have been few signs of an explosion in cash under mattresses. Instead, the fear has shifted to bank profitability. Banks have been unwilling (or legally unable) to fully pass on negative interest rates to depositors, providing a squeeze on net interest margins and profits. The fear is that this could undermine capital positions in the sector, leading to a reduced capacity to lend and driving a tightening in credit conditions. There are other avenues through which policy might prove unhelpful. Rate cuts beyond certain levels could sap confidence, as households and businesses see these as a sign of economic malaise. In economies with high domestic savings rates the lower return on these could encourage even more cautious activity. Finally, the BIS has been keen to highlight the risks of credit misallocation as interest rates fall ever lower.
Ever-lower interest rates may well generate unintended negative consequences. But there are mitigating forces at play that we need to take into account. For example, the squeeze on bank margins might be offset by higher lending, not to mention a boost from asset holdings. Indeed, while the overall evidence is mixed, most credible studies do not support the conclusion that interest rates have fallen to a level at which the unintended consequences outweigh the benefits. However, the fact that these exist adds to the case for fiscal policy to take more of the strain. Sadly, it does not feel as if governments are stepping up to the plate.
Chart 1: Breaking through the zero lower boundSource: Haver, ASIRI (as of September 2019)