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Eurozone Economy

The Days Are Numbered for Negative Policy Rates in Europe

Tomasz Wieladek, T. Rowe Price International Economist

The political costs of the tactic outweigh the benefits.

Key Insights

  • Despite using many other tools to deal with the coronavirus‑led recession, central banks have been reluctant to cut rates further into negative territory.
  • This is most likely because we have reached the political reversal rate of negative rates—the point at which the cost of cutting further outweighs the benefits.
  • As such, we have likely seen the last of negative rates as a policy tool, for the time being at least.

Faced with the biggest economic shock since World War II, European central banks have deployed their entire toolkits in response to the coronavirus‑led recession—with the notable exception of cutting rates further into negative territory. Given that in previous crises central banks have used everything at their disposal to deal with economic downturns, their apparent reluctance to push rates deeper into negative territory this time is a strong signal that we have probably seen the last of this policy for now. This is likely because central banks have hit the reversal rate—the point at which further cuts in the policy rate begin to reverse their intended effect.

Opening Quote ...European central banks have deployed their entire toolkits… with the notable exception of cutting rates further... Closing Quote

The Benefits of Cutting Interest

Rates Into Negative Territory Although cutting the central bank policy rate below zero is probably not as powerful as cutting interest rates from positive territory toward zero, it is still likely to have an impact. It affects the macroeconomy in three main ways: first, because a negative deposit rate means that commercial banks are charged to hold deposits at the central bank, providing a strong incentive to cut lending rates and support credit expansion; second, because negative rates can be used to defend against currency appreciation; and third, because if the policy rate is expected to remain in negative territory for some time, rates fall across the yield curve— decreasing the cost of government and market‑based private sector finance.

On the flipside, the main risk of deploying negative rates is hitting the reversal rate, where the costs of cutting rates begin to outweigh the benefits. Although there is no precise measure of the reversal rate, it is generally agreed that it can take three forms: economic, financial, and political. Here, I assess whether the reversal rate has been reached in any of these forms.

No Evidence That Economic Reversal Rate Has Been Hit

(Fig. 1) Money demand has not risen significantly since 2014

As of April 30, 2020.
Source: European Central Bank/Haver Analytics.

The Three Types of Reversal Rate

The economic reversal rate is the point at which households/firms start to withdraw their money from bank accounts and hold it in cash, which pays an interest rate of zero. Customers will likely pay a very small fee for storing their savings in a secure location as it is difficult to stash lots of cash under the mattress, but if that fee begins to rise, they may reconsider. The use of cash grew when the European Central Bank (ECB) first moved rates into negative territory in 2014, but this may well have reflected the beginning of the ECB’s asset purchases, which were financed by a large expansion of the money supply. There is currently no evidence, neither in theory nor practice, that the economic reversal rate has been reached in the eurozone.

The second reversal rate central banks worry about is the financial system reversal rate. Normally, lower central bank policy rates lead to lower deposit rates, which in turn allow banks to lower lending rates as well. However, if a bank cannot pass on a negative rate to customers directly, because charging retail depositors appears controversial, an alternative way to maintain profits is to raise the lending rate. When banks raise lending rates to maintain profitability, the financial system reversal rate has been hit.
This likely happened when the ECB lowered the deposit rate to ‑0.40 basis points in March 2016. To mitigate this, the ECB introduced the targeted longer‑term refinancing operations (TLTROs) in 2016, then the two‑tier remuneration system in September 2019. These tools will likely prevent the financial system refinancing rate from being hit this time around.

The political reversal rate—the point at which the political cost of cutting rates outweighs the benefits—is less widely recognized and discussed than the economic and financial reversal rates, but it should also be considered. Monetary policy always has a redistributive element from savers to borrowers since this is partly how monetary policy works; however, it is plausible that pushing rates into negative territory will have greater political implications than reducing policy rates to zero. Negative interest rates are a challenge to the idea that savings should be rewarded, especially in countries where saving is a strong cultural trait.

The fact that Alternative für Deutschland, currently the largest opposition party in the German parliament, was founded with the idea of a German euro exit suggests a degree of political resistance against ECB policies—as does the fact that the German term “strafzinsen” (“penalty interest rate”) surged in terms of Google searches in 2019, when it was expected that the ECB would cut the deposit rate further into negative territory.

Opening Quote If passed on to retail depositors, negative interest rates function like a tax. Closing Quote

If passed on to retail depositors, negative interest rates function like a tax. As such, it may be argued that negative rates are effectively a form of fiscal policy and, therefore, should be decided by elected representatives rather than independent central banks, in line with the historical slogan “No taxation without representation.” Indeed, the German Federal Constitutional Court’s ruling that the ECB’s bond‑buying program partly violates the German constitution clearly indicates that such concerns are not purely academic. Cutting policy rates too deep into negative territory may leave commercial banks no choice but to pass them on to retail depositors. This could eventually raise legal risks, which central banks would likely want to avoid.

Lending Rates Have Not Spiked Since 2016

(Fig. 2) ECB measures have reduced risk of hitting financial reversal rate

As of April 30, 2020.
Depo Rate = deposit rate.
Sources: ECB Statistical Warehouse and T. Rowe Price.

Non‑Policy Negative Rates Remain Possible

I believe that we have reached the end of the road for negative policy rates in Europe because the political costs of additional cuts could outweigh the benefits—in other words, because the political reversal rate has been hit. Monetary policymakers must always balance the costs and benefits of each tool at their disposal—a rational central bank will typically choose the instrument that has the greatest impact and, ideally, the least cost. Today, quantitative easing very likely provides a better cost/benefit relationship and a greater overall effect on the macroeconomy than negative interest rates.

However, while negative policy rates are unlikely, it is possible that central banks will resort to subsidies to support commercial bank lending operations. Such subsidies would take the form of greater negative rates on funding facilities at the central bank—in other words, the commercial bank would have to pay back less than they borrowed. This type of negative rate is a possibility going forward, especially because it does not come with the political costs of moving policy rates into negative territory. Indeed, this is exactly what the ECB did at the April 2020 meeting of its governing council when it lowered the rate on TLTROs from ‑0.5% to ‑1% without touching the policy rate.

The Market Implications of the End of Negative Rates

The central bank policy rate is the anchor of the risk‑free government bond yield curve. While financial markets continue to price negative rate cuts, our analysis suggests they are unlikely. Historically, when long‑term bond yields have rallied to yields lower than the policy rate, this indicated the onset of a recession and a cutting cycle. As the recession slowly recedes from view, our analysis suggests that there are limits in the degree to which risk‑free core bond yields can rally beyond current policy rates.

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