Can negative rates ever be positive? - Comment & Profiles -
Brian Caplen blog 2016

With the Bank of England considering negative interest rates, the experience in other countries where they have been tried is mixed.

For bankers, negative interest rates just add to the nightmare of squeezed margins and profits under pressure. There are also practical issues to deal with such as whether settlement systems designed for positive rates can cope operationally with negative ones.

Critics argue that negative interest rates are just a further extension of quantitative easing and have the same broad impact. While they provide a stimulus in their early use, the effect dissipates over time while risk to the economy builds as companies and households borrow too much and investors chase after yield.

Advocates on the other hand would say that negative interest rates encourage bank lending and are an essential policy tool in a disinflationary environment that has now become even more critical following the demand and supply shocks caused by Covid-19.

Predictably, the evidence from those countries that have implemented negative rates – the euro area, Sweden and Denmark – is decidedly nuanced. A critical question is whether banks even pass on the negative rates given the challenge in explaining to customers that they will be charged for holding deposits.

Denmark has mostly held its key policy rate negative since 2012 and a recent paper by three central bank economists suggests that transmission is working but pass through to lending rates is slower than when rates are positive. They acknowledge the problem of great risk taking but also argue that firms have responded by increasing investment and employment.

What no-one can know is how an economy that has had negative interest rates would have fared without them and why if there are good investment opportunities do firms only engage with them when rates are negative?

In contrast two academic economists, commenting on the Swedish experience with negative rates between 2015 and 2019, start their paper with the plea ‘Don’t do it again’. They contend that the impact on inflation was small whereas property prices have risen rapidly along with levels of household debt. Wealth inequality has increased as a result. They argue that the Riksbank had the authority to revise the inflation target downwards but instead chose to engage in a negative rate ‘experiment’ that has lessened its scope for dealing with subsequent downturns.

In the euro area negative interest rates have been in place since 2014 with the aim of bringing down stubbornly-high rates in Italy and Spain. Success in the euro area is more difficult to judge than in Sweden and Denmark given the number of countries involved and more complex policy options. But for its part, the ECB argues that the impact on bank profitability has been offset by better economic conditions, fewer defaults and lower NPL provisions. It also claims that as in Denmark there has been an increase in corporate investment.

As the Bank of England contemplates negative rates, it should be asking lots of questions about these findings. What no-one can know is how an economy that has had negative interest rates would have fared without them and why if there are good investment opportunities do firms only engage with them when rates are negative? There could indeed be positives from negative rates but as with QE they don’t solve underlying economic health issues such as how to boost productivity and develop the industries of the future. They are a panacea at best and they may prove costly in the long run if the greater risk they promote turns into a financial crash. On current evidence, the jury must remain out.

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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