Should the Bank of England Adopt a Negative Interest Rate Policy?

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Compare and contrast Forward Guidance and Negative Interest Rates as unconventional monetary policy tools. The October 2018 Budget forecasts low output growth in the UK over the next 5 years. In the light of this, would you recommend that the Bank of England adopt a policy of negative interest rates?

 

Following the global financial crisis, Central Banks worldwide implemented aggressive interest rate cuts in order to revive their economies. However, when eventually the zero-lower bound on interest rates was reached and it was evident that conventional monetary policy was insufficient to stimulate recovery, major central banks in continental Europe, the UK, the USA and Japan adopted a variety of unconventional monetary policies to “restore the functioning of financial markets” (Dell’Ariccia, Rabanal, Sandri, 2018, p.147). These included negative interest rate policy (NIRP) and forward guidance (FG). While NIRP aims to stimulate the economy by “encouraging banks and other entities to lend or invest excess funds rather than pay penalties on funds in [central] bank accounts” (Wohle, 2017), FG “aims at influencing future interest rates via pledges to keep them low” (De Vita & Berger, p.289), meaning that current economic conditions may be influenced by guidance about future policy rates, which can be explained using expectations theory of the term structure of interest rates (Wood, cited in ibid., p. 290). NIRP and FG have both had some success in increasing output growth and stimulating economic recovery; the most significant comparison between them however, is that both policies seem to promote uncertainty which hinders, and perhaps even reverses, the intended effects of promoting growth and increasing inflation. Conversely, the main difference between the two policies seems to be the degree to which they rely on the bank lending channel, which in the case of NIRP is inherently weakened due to banks’ profitability concerns. However, clear communication about policy intentions, and about NIRP particularly, seems to strengthen the success of both policies. In light of this, the adoption of NIRP to combat forecasted short-to-medium term output growth is unwarranted, even more so given the historically short period that NIRP has been implemented.

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The similarities between FG and NIRP are evident through the limited success of the policies in encouraging economic growth, and more importantly through the high level of uncertainty caused by both. Both policies have been largely unsuccessful – while NIRP is constrained by banks’ fear to pass on negative interest rates to depositors, FG may fail to alter expectations. The partial success of NIRP largely stems from the limited translation of negative bank rates onto commercial bank deposit rates. As shown by Borio and Zabai, “rates have only been partially transmitted to wholesale deposit rates and … not at all to retail deposits. Banks are reluctant to do so, presumably out of concerns with the reaction of depositors.” (2016, p.20) Furthermore, NIRP’s limitations in encouraging financial recovery and economic growth are trifold. (Borio, Zabai, 2016, p.20) First, if policy rates are not transmitted to lending rates, the demand for loans will not increase, thereby having no effect over aggregate demand. Second, if they are transmitted to lending but not to deposit rates, in the long-term banks’ ability to lend may be impaired since their profits are squeezed. Last, if they transmit to both lending and deposit rates, depositors may withdraw money, “making it harder for banks to attract funds” (Borio, Zabai, 2016, p.20), thereby obstructing banks’ lending abilities which could have significant negative repercussions on demand-side growth. This argument is limited, however, by Jobst and Lin’s observation that there is insufficient evidence of cash hoarding in countries with more negative deposit rates. (2016, p.18) Arguably, NIRP can only work if it is expected that it will be a short-term policy as otherwise it could provide a greater incentive for significant substitution into cash, or squeeze bank profitability which could lower the credit supply, thereby diminishing, if not reversing, the intended increase of aggregate demand. (Charles Bean, 2013, p. 7) Instead, as suggested by Kimball, bounds to NIRP can be overcome by the introduction of a time-varying exchange rate between paper-currency and money in the bank. (2015, p.R7) Thus, once paper currency is no longer a problem, the target rate can be lowered below zero by open market purchases of short-term treasury bills, “the most conventional of tools”. (ibid., p.R10) Similarly, the effect of FG is questionable as the evidenced by contradictory studies for the UK, Japan and the US. Dell’Ariccia et el. highlight Filardo and Hoffman’s conclusions that FG “announcements in 2013 and 2014 did not lead to a reduction in expected future rates or in government bond yields” (2018, p.163), therefore leading to little change in investment and spending, strengthening the view that FG scarcely helped stimulate aggregate demand and generate growth. This is further supported by the mixed evidence available for Japan, which suggests that FG helped stabilise financial agents’ expectations but only somewhat altered market expectations, meaning that aggregate demand was hardly influenced. (De Vita, Berger, 2015, p.291-2) Studies on the effect of FG in the US also produce mixed views, suggesting that while unexpected policy announcements somewhat lowered interest rates, FG in general did not “improve market participants’ ability to forecast future short- and long-term rates” (idib., p.292), further supporting the view that FG ultimately did not help to revitalise economic conditions. Arguably, this is because “regardless of whether FG is implicit, time-based or threshold-based, the distinction between making a commitment versus providing a forecast regarding future policy is fundamental” (Floro, Tesfaselassie, 2013, p.7). This, along with the fact that FG can be easily misinterpreted (De Vita, Berger, 2015, p.290), suggests that this policy tool was largely ineffective at influencing the broader economy because central banks’ announcements following the crisis were found unreliable, thereby fundamentally impairing its ability to stimulate recovery.
The similarity between FG and NIRP is also made apparent by the uncertainty both polices promote. While NIRP may increase private sector and banks’ cautiousness, thereby reducing lending and expenditure as it can be seen as an indicator of serious macroeconomic problems, FG can “dent consumer and business confidence” when by announcing “that interest rates will remain low for longer than expected” (Dell’Ariccia, 2018, p.150), the central bank effectively signals it is more seriously concerned about future economic prospects than previously believed. The “deteriorating investor confidence and declining risk-taking behaviour [which] could intensify the potentially adverse impact of negative rates” (Jobst, Lin, 2016, p.22), coupled with  evidence of commercial banks’ reluctancy to lower their interest rates due to riskiness because of fear that “reduction of savings rate … [may] be met with customer resistance” (Charles Bean, 2013, p.4), will evidently diminish the intended effects on aggregate demand and will not stimulate growth. Similarly, as suggested by evidence from the UK, whereby instead of providing clarity about future rates, FG “breeds more confusion” (De Vita, Berger, 2015, p.294), the increase in uncertainty will have no effect over long-term rates, and consequently output and inflation. Furthermore, even though NIRP aims to effectively “subsidise borrowing”, the uncertain economic outlook following the financial crisis may have hindered potential borrowers’ ability to repay loans, thus they simply did not take out any loans. (Whole, 2017) This is supported by evidence form Denmark which shows that there was “little change in household borrowing” (Charles Bean, 2013, p.4-5), suggesting that NIRP did not increase investment and thus demand. Likewise, FG may have bred “more pessimism in the markets” by giving the impression that the crisis will endure for longer, thereby inducing a decline in consumers’ and investors’ expenditure. (Bullard, cited in Belke, 2013, p.359) Overall, the evidence suggests there are strong similarities between FG and NIRP in their limited success and the uncertainty they both caused in banks, investors and consumers.

Conversely, while it could be argued that NIRP is more of a short-term tool and FG is more long-term, the strongest difference which this essay will examine is that although both policies depend on the functionality of the bank lending channel, in the case of NIRP this channel is impaired as banks’ profitability is threatened. The link between FG and banks’ interest rates is evident as “lowering forecasts of the future base rate will reduce the rates paid on fixed-interest longer-term loans” (De Vita, Berger, 2015, p.290), which encourages more spending and investment, thereby boosting demand. NIRP on the other hand hopes to stimulate economic growth by “encouraging banks and other entities to lend or invest excess funds rather than pay penalties on funds in bank accounts” (Wohle, 2017), with increased lending being reliant on lower interest rates. The difference between FG and NIRP largely stems from NIRP being majorly reliant on banks’ willingness to pass on lower rates to both depositors and borrowers effective immediately, while FG relies on all market participants to engage in higher investment and consumption, without putting a heavy strain on the banking system. Furthermore, in the case for NIRP as suggested by Jobst and Lin, the “lending channel is crucially influenced by banks’ expected profitability” (2016, p.27), and as established earlier banks’ have been reluctant to lower their deposit rates, even if they have lowered lending rates. This effectively compresses bank profitability (which can only be sustained for a short while anyway), consequently “[constraining] credit expansion and [undermining] the aim of monetary easing.” (ibid., p.27-8). Therefore, the key difference between NIRP and FG is evident, showing that perhaps FG is a more reliant unconventional tool to revitalise the economy. However, despite their differences and limitations, evidence suggests that FG helped the effectiveness of NIRP, and vice versa. It can be inferred that NIRP works better when coupled with FG as “as decisions were expected and less of a shock”. (Saedi, 2017, p.6) This is further supported by the downward shift in yield curves in Germany on the first days of NIRP announcements (Dell’Ariccia et el., 2018, p.160), along with the fact that in Japan “clear and strong communication of a commitment to [NIRP] policy was a critical … factor in the decline of long rates” (ibid. p.19). Equally, NIRP “enhanced the ECB’s forward guidance while inflation and inflation expectations have remained subdued. (Jobst, Lin, 2016, p.21), clearly emphasising both policies’ success in improving economic conditions when simultaneously used. It is therefore evident that despite the limitations and differences between NIRP and FG individually, when used together they have brought about significant financial and economic improvements.

The questionable success of negative interest rate policy, along with the historically short window for comparison and the small number of countries who have adopted NIRP to date, are the main reasons for which I cannot recommend the adoption of this policy in the UK. Although output growth is forecasted to be low in the UK over the next 5 years at 1.75% per year, this could lead to growing inflationary pressure if aggregate demand is pushed into excess as is the intention of NIRP. (IFS Green Budget, 2018, p.59) As inflation is currently at 2.4% and will most likely rise due to Brexit, the case for NIRP introduction if further weakened. Moreover, the fact that the Bank of England so far has been reluctant to lower rates below zero opting instead for “more reliable tools for stimulating aggregate demand” (Charles Bean, 2013, p.7)such as Quantitative Easing, coupled with the fact that demand is forecast to be low only in the short-to-medium term, suggests that NIRP should not be implemented in the UK. My recommendation is not to lower rates below zero unless absolutely necessary, and if need arises to do so, perhaps an exchange rate between paper currency and bank currency should be considered, as mentioned earlier.

In conclusion, FG and NIRP have both had partial success in improving economic conditions following the financial crisis. The uncertainty of the period itself, exacerbated by that generated by the policies, put further strain on banks’, investors’ and consumers’ willingness to lend, borrow, invest and increase expenditure, thereby limiting the extent to which the policies worked. The main difference highlighted in this essay is that commercial banks’ concern over their profitability was the main reason for the failure of NIRP to improve economic conditions, a problem not faced by FG which relies on all economic agents’ belief that interest rates will remain low for an extended period in order to boost aggregate demand. Despite this, it is evident that FG and NIRP work well together at lowering yields and thereby boosting demand. In the light of all this, I have concluded that the implementation of NIRP as a tool to combat the expected low growth in the UK over the next 5 years is unnecessary unless market conditions are dire enough, since the costs far outweigh the limited success of the policy.

REFERENCES:

 

 

  • Bean, B. (2013). Letter from Charles Bean to Andrew Tyrie on negative interest rates, [online], pp. 1-8. Available at: https://www.bankofengland.co.uk/letter/2013/charles-bean-negative-interest-rates-may-2013 [Accessed: 9 Nov. 2018]
  • Belke, A. (2013). Non-Standard Monetary Policy Measures – Magic Wand or Tiger by the Tail?, Review of Economics, Bd. 64, H. 3, pp. 341-364
  • Borio, C. and Zabai, A. (2016). Unconventional monetary policies: a re-appraisal. BIS paper, pp.1-43.
  • Dell’Ariccia, G., Rabanal, P. and Sandri, D. (2018). Unconventional Monetary Policies in the Euro Area, Japan, and the United Kingdom. The Journal of Economic Perspectives, Vol. 32, No.4, pp. 147-172
  • De Vita, G., & Berger, W. (2015). ‘Forward guidance’: New monetary policy instrument or esoteric fad? Public Money & Management, 35(4), pp. 289-296.
  • Emmerson, C., Farqunharson, C. and Johnson, P. (ed). (2018). The IFS Green Budget, The Institute for Fiscal Studies, pp.1-344
  • Floro, D. and Tesfaselassie, M. (2013). Can forward guidance be ambiguous yet effective? Kiel Institute for the World Economy, No. 65, pp.1-11
  • Jobst, A., & Lin, H. (2016). Negative Interest Rate Policy (NIRP): Implications for Monetary Transmission and Bank Profitability in the Euro Area. IMF Working Papers, 16(172), pp.1-48.
  • Kimball, M. (2015). Negative Interest Rate Policy as Conventional Monetary Policy. National Institute Economic Review, 234(1), pp. R5-R14.
  • Saedi, D. (2017). Breaching the Zero Lower Bound: Are Negative Interest Rates an Effective Monetary Policy Tool?, University of California, Berkeley, Department of Economics, pp.1-32
  • Wohle, C. (2017) An Insider’s Guide to Negative Interest Rates, [online]. Available at: http://www.babson.edu/executive-education/thought-leadership/finance/Pages/insiders-guide-negative-interest-rates.aspx [Accessed: 10 Nov. 2018]

 

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