Entertaining NIRP: the beatings will continue!

Peter Warburton - October 23, 2020

Andrew Bailey, governor of the Bank of England, has ordered the UK commercial banks to demonstrate their preparedness for the possible introduction of a negative interest rate policy (NIRP). From one perspective, this is merely a prudent step that enhances the central bank’s policy toolkit. From another, it is a further unwarranted and ill-advised step towards the complete abandonment of monetary control.  Only in an analytical model can it be argued that negative nominal interest rates have beneficial long-term economic effects. Rather than arbitraging reality to the model, we recommend the opposite course of action.

Advocates of NIRP argue that, even though the classical interest rate channel is weaker, there is a more than offsetting positive signalling effect, reducing expectations regarding short-term money market interest rates (see figure 1) and long-term government bond yields, that it boosts inflation and GDP growth expectations and, by lowering real interest rates, boosts aggregate demand. This assertion is based on a New Keynesian analytical model which imposes two conditions. First, that policymakers set policy in a time-consistent manner and second that central banks change interest rates only gradually. Such models generally fail to take account of moral hazard behaviours or the impacts on financial stability.

At best, NIRP is a gimmick that has favourable short-term announcement effects, such as gains in asset prices that strengthen bank balance sheets. The experience of countries that have persevered with NIRP is that the trouble it causes cumulates over time. Notably, the Swedish Riksbank abandoned negative rates at the end of 2019 in the face of mounting evidence of adverse side-effects. Examples of the unintended consequences of NIRP are the erosion of the returns to long-term saving institutions to the point of undermining their solvency; the sustenance of zombie companies that would collapse without cheap money and the incitement to reckless borrowing; perverse effects on household saving rates and an increase in the hoarding of physical cash (see figure 2); and the erosion of Euro area bank profitability through negative rates paid to the ECB in the context of Target-2. Banks that cannot earn an adequate net interest margin from domestic credit intermediation are likely to be driven to risky lending activity in foreign parts.

A comprehensive critique of NIRP would require many more words than this blog affords. My objections are summarised under four headings. First, while policy is made in nominal terms, it is real interest rates that matter most. Negative real interest rates do not require negative nominal rates. Second, negative nominal rates, even more than zero rates, signal the desperation of policy makers and engender fearful, precautionary and radical responses in the general population. Third, negative nominal rates are more likely to motivate risky foreign lending than safer domestic lending in the commercial banking system. Finally, negative nominal rates play havoc with the business models and undermine the solvency of the pension fund and life insurance industries at a time when these institutions are already challenged by adverse demographic trends. 

A previous blog described the essential features of central bank socialism, which asserts that it is the moral duty of savers, and saving institutions, to accept low or zero returns in aid of the higher purpose of building tomorrow’s infrastructure and protecting the environment. NIRP is an extension of the argument, reductio ad absurdum. The beatings will continue until morale improves!

Figure 1: US implied rate probabilities


Note: Market-implied probabilities of three-month LIBOR (USD) rates setting below −0.25  percent at December 15 of 2018 through 2021. Market-implied probabilities are derived from options prices on the Eurodollar futures with strikes of 100.25 and 100.5, which correspond to LIBOR rates of −25 bps and −50 bps, respectively. Probabilities are lower bounds and are estimated assuming risk neutrality, averaged over the preceding month. Eurodollar option price data from Bloomberg. See Lilley and Rogoff (2019) for details.
Lilley, A, and K Rogoff (2019), “The Case for Implementing Effective Negative Interest Rate Policy, Strategies for Monetary Policy, (Stanford: Hoover Institution Press) 

Figure 2

Data source: ING International Survey


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