Macroscope: How low can you go?


Executive summary

Central banks are rushing to provide additional support as the economic outlook darkens. However, there are growing fears that policy loosening might be doing more harm than good at present.

This so-called ‘reversal rate’ at which rate cuts become counterproductive is seen as working through a number of channels, including weak bank profitability; credit misallocation; softer household and corporate confidence; and low returns on saving.

But although there are some justifiable concerns over the unintended consequences of lower rates, we need to take into account the whole picture. For example, the drag on bank margins from a lower interest-rate structure might be offset by higher lending volumes.

Indeed, most empirical evidence does not suggest that the costs of lower interest rates are outweighing their benefits, suggesting that policymakers have not reached a reversal rate - yet.

This debate is a symptom of how much pressure is being put on monetary policy. Looser fiscal settings would constitute a better policy mix, but there are few signs of governments stepping up to the plate.


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James McCann

Paul Diggle

Luke Bartholomew

Jeremy Lawson

Govinda Finn

Gerry Fowler


James McCann

Chart Editors

Yashaswini Dunga

Nancy Hardie



Chapter 1


James McCann, Senior Global Economist

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 bound

Source: Haver, ASIRI (as of September 2019)


Chapter 2


James McCann, Senior Global Economist

Staying positive

The Federal Reserve (Fed) has cut rates twice this year and continues to signal that it will “act as appropriate” to keep the expansion on track. We think more help will be required and cuts will be delivered in October and December, which would take the fed funds target range to 1.25–1.5%. This is, of course, still some way above the low of 0–0.25% reached in the wake of the financial crisis, with the Fed enjoying more monetary policy ammunition than most of its developed market peers.

The Federal Reserve refused to dabble in negative interest rates after the financial crisis and looks reluctant to experiment with these in the future.

However, what if the Fed were forced to cut rates more aggressively? Certainly, it would slash rates down to this record low. Indeed, the long-running decline in equilibrium interest rates suggest that visits to the zero lower bound will be increasingly frequent (see Chart 2). But would the Fed dare push policy even lower? This opens up an interesting question as to where the effective lower bound for policy should sit. Or in other words, at what point do rate cuts stop delivering stimulus, or even become counterproductive? Other central banks have pushed rates into negative territory – could the Fed follow them there?

The Fed’s choice to keep rates positive after the crisis was in part a driven by technical concerns. First, it was uncertain over the legality of charging banks interest on excess reserves. Chair Yellen flagged this to Congress as something that would need to be resolved before the Fed could implement negative rates. Second, there were fears that negative rates could pose challenges for money-market funds. These could come under pressure if investors feared losses, sparking a squeeze in short-term funding markets. Regulatory changes have lessened, but not eliminated, these concerns.

There were also more fundamental reservations, however. High on the list was a concern that negative rates would push deposits out of the banking sector as people looked to avoid these levies. The experience of negative rates in other economies is likely to have lessened these worries. More recently, the concern has switched to the impact of negative rates on bank profitability. The banks’ net interest margins narrowed after the crisis as interest rates fell (see Chart 3), and there could be a more abrupt squeeze should banks struggle to pass negative rates on to depositors. But we need to keep in mind that a range of factors determines bank profits, including lending volumes and the return on other assets. Indeed, it is not clear that modestly negative rates would provide such a squeeze on profits to make these counterproductive.

This debate may be academic. Chair Powell has played down the prospect of the Fed using negative rates, preferring forward guidance and asset purchases as the primary policy tools at the zero lower bound. This might reflect the lingering technical concerns around implementation. Moreover, it is probably true that loosening at this point starts to generate some costs for banks. However, we do not think that these outweigh the aggregate benefits, at least at modestly negative interest rates.

Chart 2: The long decline in the neutral rate

Source: Federal Reserve Bank of New York, Haver, (as of Q2 2019)

Chart 3: Bank margins have been on the decline

Source: Federal Reserve Bank of New York, Haver, ASIRI, (as of Q2 2019)
The Federal Reserve refused to dabble in negative interest rates after the financial crisis and looks reluctant to experiment with these in the future.


Chapter 3


Luke Bartholomew, Investment Strategist

No deal Brexit would push rates to the effective lower bound

UK GDP contracted by 0.1% (month on month) in August but an upward revision of July’s figure to 0.4% means that the UK economy is now likely to avoid a technical recession, as GDP across the whole of the third quarter is likely to have expanded (see chart 4). Therefore, despite the ongoing Brexit uncertainty and weak global growth, we expect the Bank of England (BoE)to keep policy on hold this year. In the event of a no-deal Brexit, however, we would expect the BoE to cut rates to 0.1%, which is our estimate of the effective lower bound. The BoE’s own estimate of where this lower bound lies has changed over time as it has introduced new tools.

The Bank of England has lowered its estimate for the effective lower bound on interest rates, but still sees this as being in positive territory.

Following the financial crisis, the BoE cut rates to 0.5%, leaving them somewhat higher than in the US. At this point, it was thought that the negative impact of further rate cuts on certain banks – building societies in particular – would outweigh the other benefits of lower rates. This is because many UK banks had lending products explicitly linked to the level of Bank rate, especially tracker-rate mortgages. As Bank rate falls, the return on these products will obviously also fall. Normally, banks can offset this effect by cutting the return they offer on deposits, so reducing their funding cost at the same time. However, as rates get closer to zero, there tends to be a much smaller decrease in deposit rates as consumers react adversely to lower interest rates. So banks with a large number of variable rate mortgages faced significantly squeezed margins as funding costs fell less than the return on assets, damaging their profitability. In the context of the financial crisis, where banks were writing down assets and generally distressed, the BoE thought it would undermine financial stability to cut rates lower than 50bps.

As banks recovered from the crisis and the terms of mortgage products were re-written over time, this issue became less pressing. However, there remains a more general point that as rates fall towards zero, it tends to be hard for banks to continue reducing their funding costs. As such, they tend not to reduce their lending rates as much as a cut in Bank rate would imply. Indeed, in the extreme, banks could even increase lending rates on new products to make up for margin squeeze on existing products. This leads to monetary policy transmission being impaired, as cuts are not fully passed through to the economy.

To get round this issue, when the Bank cut rates to 0.25% in August 2016 following the Brexit referendum result and associated slowdown in the economy, it also introduced a Term Funding Scheme (TFS) to enhance the transmission of this cut to the real economy. The scheme provides funding to banks at a rate very close to the policy rate, reducing their funding costs and allowing them to pass this through in lower lending rates (see chart 5). In a speech in 2019, Governor Carney explicitly linked TFS to the BoE’s estimate of the lower bound, saying “the existence of the TFS meant that the MPC reduced its estimate of the effective lower bound from 0.5% to close to, but a little above, 0%”. It should be said that while this extra space to cut is welcome, it is likely to have a relatively small macroeconomic impact and would certainly not offset the shock of no deal.

Chart 4 : UK likely to avoid recession...for now

Source: ONS, Bloomberg, (as of August 2019)

Chart 5: TFS helped transmit rate cuts to the economy

Source:ONS, Haver, ASIRI (as of September 2019)
The Bank of England has lowered its estimate for the effective lower bound on interest rates, but still sees this as being in positive territory.


Chapter 4


Paul Diggle, Senior Economist

We can’t find reverse

European monetary policy isn’t at the ‘reversal rate’. But the returns due to additional monetary-policy stimulus may well be declining, which increases the onus on fiscal and structural policies to support growth.

The evidence does not suggest that the European Central Bank’s policy has reached a reversal rate, opening the door for lower interest rates.

There is a growing concern among some economists and market participants that further monetary-policy easing – especially ever-more negative interest rates – would be a drag, rather than a support, for the growth and inflation outlook in Europe. The plausible channels through which this ‘reversal rate’ could operate include a destabilising substitution away from bank deposits into physical cash; pressures on banks’ net interest margins and therefore lending activity; higher savings rates as households put aside ever more cash to meet a nominal savings target; and lower consumer and business confidence as agents interpret negative rates as a signal of economic weakness.

But while this is theoretically possible, there is little evidence that the European Central Bank (ECB) or other European central banks have reached the reversal rate. Households have not substituted into physical cash. Eurozone banks’ net interest margins did fall sharply when the ECB cut rates to negative (see chart 6). But their return on assets has actually ground higher since then, reflecting lower default rates and capital gains on fixed-income portfolios, both the direct consequence of policy easing. In any case, the banks’ lending growth has turned from negative to positive in the years since the ECB took policy rates negative (see chart 7). Meanwhile, the household savings rate has remained fairly steady even as bank deposit rates have declined in tandem with the policy rate. And consumer confidence is higher now than it was when the ECB first introduced negative interest rates.

European monetary policy may not be at the point where it is actively unhelpful, but the returns due to additional easing may well be declining as every additional rate cuts simply takes us closer to the reversal rate. The upshot is that calls for fiscal policy to take up more of the burden of counter-cyclical macroeconomic management, and structural reforms to raise potential growth, are only going to increase.

European governments are inching towards more expansionary fiscal stances, but not by enough to take the burden entirely off the shoulders of monetary policy. And the structural reform agenda continues to proceed at a snail’s pace. We therefore expect additional central-bank easing by both the ECB and other European central banks as the growth environment is buffeted by trade uncertainty and a deep manufacturing contraction.

Chart 6: Volumes outweigh value

Source: Datastream, ASIRI (as of October 2019)

Chart 7: Lending expanding, not contracting

Source: Datastream, ASIRI (as of October 2019)
The evidence does not suggest that the European Central Bank’s policy has reached a reversal rate, opening the door for lower interest rates.

Japan and
developed Asia

Chapter 5


Govinda Finn, Japan and Developed Asia Economist

You don’t know until you’ve tried it

Japan is often the focus of attention for those looking for evidence of the existence of a so-called reversal rate. On the face of it, the country does appear to offer fertile hunting grounds. It has experienced a large and persistent gap between actual inflation and target growth in the price level despite interest rates having been close to zero for more than 20 years.

The reversal rate may be higher in Japan than elsewhere, but worries about the point where expansionary policy becomes contractionary should not detain the Bank of Japan.

To narrow down the search area, we identify three necessary conditions that would significantly raise the risk of a reversal rate and look for evidence of their existence in Japan. First, is there a low pass-through of negative interest rates from banks to their customers? The simple premise here is that the availability of cash as an alternative to bank deposits removes banks’ pricing power over deposit spreads. In Japan, the evidence suggests the zero-lower bound constraint is more prevalent than elsewhere because of the relatively high degree of cash transactions (see Chart 8). Indeed, cash hoardings, rather than cash for transactional purposes, are estimated to have grown in recent years to a remarkable 42% of total cash in circulation.

A second criterion is the inability of banks to find sufficient profit opportunities to fully offset the fall in earnings from core maturity-transformation activities. In theory, banks should be able to respond to declining net interest margins by 1) expanding loan volumes, with lower provisions as corporate creditworthiness improves; and 2) focusing more on expanding fee-based income. On the former, there is little evidence that demand for corporate loans has been meaningfully affected by the shift to negative interest rates in 2016 (see Chart 9). As for the latter, the Bank of Japan (BoJ) has until recently shunned responsibility for weak bank profitability, preferring to point the finger at overbanking issues and the need for sector consolidation. That message changed abruptly with the publication of the BOJ’s latest Financial System Report in April, which highlighted the systematic nature of low fee-based revenues in Japan compared with international peers.

The final criterion relates to the effectiveness of the capital constraint. A persistent deterioration in banks’ ability to generate capital internally through retained earnings is likely to reduce their resilience to exogenous shocks or force them to shrink balance sheets. Of particular concern is the regional banking sector, which has been unable to pursue the international opportunities for income growth of its larger peers and has not introduced either negative deposit rates or raised fee-based revenues. In aggregate then, we are sympathetic to the notion of policy becoming less effective in Japan and see risks of a reversal rate taking hold in this economy. Without historical precedent, the exact threshold for this is extremely difficult to estimate. The BoJ’s price mandate necessitates it to explore the limits of further easing and go beyond them if necessary.

Chart 8: Cash is king

Source: The curse of cash, Kenneth Rogoff (as of 2016)

Chart 9: Credit channel muted

Source: Bank of Japan, Haver, ASIRI (as of Q2 2019)
The reversal rate may be higher in Japan than elsewhere, but worries about the point where expansionary policy becomes contractionary should not detain the Bank of Japan.


Chapter 6


Jeremy Lawson, Chief Economist

Reversal rates but not as you know them

As the Fed commences a new easing cycle and the ECB pushes its own policy rate deeper into negative territory, the topic du jour among market watchers is whether there is a ‘reversal rate’ – a policy rate beyond which easing does more harm than good. But like most things macro, the concept of reversal rates has to be approached differently when considering emerging markets.

Emerging markets are generally not facing a reversal rate, although they have the spillovers from developed-market policy to contend with.

Let’s start with the facts. When we look across the BRICs and the other large emerging economies we follow, none have negative policy rates, and in only four of them – Brazil, China, Hungary and Poland – are nominal policy rates currently at their lows of the past 15 years. Indeed, when we take a simple average across the 14 economies included in this particular analysis, the average nominal policy rate is 5.5%, 0.5 percentage points (ppts) above the 15-year low recorded in the spring of 2010.

Now, one might argue that a 0.5-ppt gap is not large, and with policy likely to be eased further, a new ‘average’ low is probably not far away. Does that then mean that average emerging-market (EM) policy rates are on the verge of becoming dangerously loose? We think not. Nominal policy rates are not the right way to characterise the stance of policy; it is much better to focus on real rates. And there, because average EM inflation has been on a downward trend over time and has often been much higher in the past, the average real policy rate across those same economies is actually a little above its 15-year average (see Chart 10). In other words, in the aggregate, EM policy is best characterised as neutral rather than loose at present.

Of course, the average masks a great deal of dispersion (see Chart 11). As was the case with nominal rates, real rates are at 15-year lows in both Poland and Hungary, as their orbit around the ECB has forced them to keep policy very accommodative even as inflation has been rising. But elsewhere, there are seven economies – India, Indonesia, Mexico, Nigeria, Russia, Thailand and Turkey – where the current real policy rate is more than 5 ppts above the low of the past 15 years, and another two – South Africa and South Korea – where real rates are above the average over that period.

Overall, investors should find this analysis reassuring – nominal policy rates may be mostly low, but real policy rates are not – implying that there is still plenty of space to loosen policy further if macroeconomic conditions require. But there is a wrinkle. Emerging economies are not always in charge of their policy destinies. In particular, when the US dollar is rising and the tide of global risk appetite is going out, EM central banks can be forced to tighten policy even when growth is deteriorating, particularly in those economies with acute imbalances. Argentina and Turkey in 2018 and early 2019 are cases in point. The upshot is that there is no fixed reversal rate in emerging economies. Instead, the reversal rate is often whatever real interest rates foreign investors require to keep broader financial conditions accommodative.

Chart 10: Nominal rates lower than real rates

Source : Haver,ASIRI ( as of September 2019)

Chart 11: Few countries with utltra- loose policy

Source : Haver, ASIRI ( as of September 2019)
Emerging markets are generally not facing a reversal rate, although they have the spillovers from developed-market policy to contend with.


Chapter 7


Gerry Fowler, Investment Director, Global Strategy

The ‘reversal rate’ would be another problem for banks

In the macroeconomic sections above, the focus has been on whether record-low central-bank interest rates ‘reverse’ the usual effect of monetary policy loosening and instead tighten financial conditions. This theoretical process runs through a range of channels, but many of them are in the banking sector. On this front, the fear is that lower interest rates could weigh on net interest margins and in extremis push deposits out of the banking sector. This might limit banks’ ability to pass through lower interest rates to the real economy and in some cases even force them to contract their balance sheets, lowering credit availability.

Low interest rates have not been the only headwind for the banking sector since the crisis.

The financial sector has a range of issues to deal with at present. Indeed, what banks need most in order to maximise the effectiveness of lower policy rates is 1) demand for credit, 2) an ability to lend at high leverage ratios and 3) for that the lending to be done at higher net interest margins – where curve steepness helps a great deal.

So if our starting point were healthy banking systems growing their loan books’ profitability, the debate around the reversal rate might garner more attention with investors. Instead, many banking systems, particularly those in Europe, are already struggling for profitability a decade on from the financial crisis and not just because of crimped margins.

Post-crisis regulatory capital requirements more than quadrupled in some cases. Banks needed to raise and retain substantial levels of new capital in order to comply. Lending is now done at much lower multiples that require higher margins to maintain profitability. However, weak growth, economic uncertainty, ageing populations and already high levels of debt have been drivers of lower demand for credit through the cycle.

Reduced profitability since the crisis has affected banks worlwide. However, the problems have been most acute outside the US where the banking sectors are valued at well under 1x book value – crudely implying an expectation of terminal unprofitability (see Chart 12). Bond yields are a useful measure of market expectations for long-term growth and inflation, so it is no surprise that as European bond yields moved deeply negative, bank stocks continued to underperform other equities (see Chart 13). The cocktail of low growth, inflation and rates is clearly an unpalatable one for this sector.

A more holistic approach to raising growth and inflation expectations may be necessary. Monetary policy may not be reaching reversal rates, but its efficacy may lessen as interest rates plumb new depths. Dramatically higher banking-capital requirements, weak growth, ageing populations and high levels of debt continue to pose challenges for the sector. It is no surprise that there is a growing chorus seeking more significant efforts from governments to restructure and stimulate growth.

Chart 12: Bad debt/ demographics and high capital constraints can lead to weak banking profitability

Source: Bloomberg, ASI (as of August 2019)

Chart 13: Low growth inflation expectations in bond yields are reflected in weak bank sector performance

Source: Bloomberg (as of September 2019)
Low interest rates have not been the only headwind for the banking sector since the crisis.