The US Federal Reserve and the Bank of England have already taken action to curb inflation, raising interest rates earlier than the ECB. The announcement came as a surprise as the bank had initially hinted that it would hike the rate by 25 basis points only. Federal Reserve set to introduce privacy-crushing digital currency that can be ‘controlled’ and ‘programmed’ by government bureaucrats. That, in turn, boosted the European economy by making its goods more attractive to foreign buyers.
Second, NIRP increases investor demand for longer-dated assets, exerting further downward pressure on the term premium. The negative remuneration of excess liquidity and its transmission to short-term interest rates create incentives for investors to rebalance their portfolios towards assets with longer maturities, increasing the demand for these securities relative to their supply. Overall, negative interest rates have supported economic activity and ultimately contributed to price stability. As a result of NIRP, lending volumes have expanded and the creditworthiness of borrowers has improved, thereby mitigating the impact of lower interest margins on overall bank profitability.
What else is the ECB doing to support the euro area economy and financial markets?
In the extreme, the effect could be such that banks charge higher interest rates on their lending activities, thereby reversing the intended accommodative effect of monetary policy. Since banks are generally reluctant to pass on negative rates to their retail clients, mainly for competitive, but also for legal reasons, the funding conditions of deposit-taking institutions typically fail to drop in tandem with the decline in lending rates. This effect is particularly pronounced for banks with a high deposit-to-asset ratio.
See “ESRB issues five warnings and six recommendations on medium-term residential real estate sector vulnerabilities”, press release, ESRB, 23 September 2019. For more details, see the article entitled “Measuring and interpreting the cost of equity in the euro area”, Economic Bulletin, Issue 4, ECB, 2018. There is considerable uncertainty as to the precise level of the “reversal rate” and current estimates suggest that the ECB has not reached the effective lower bound. Screen for heightened risk individual and entities globally to help uncover hidden risks in business relationships and human networks. Access unmatched financial data, news and content in a highly-customised workflow experience on desktop, web and mobile.
The supply of central bank reserves available in the banking system determines which of the ECB’s key interest rates anchors short-term rates . If the central bank provides sufficient reserves to just match the demand in the banking system arising from reserve requirements and autonomous factors, market participants tend to price the cost of overnight funding close to the interest rate on the MRO. In an environment of excess liquidity, however, overnight rates are grounded by the DFR.
Negative rates and the transmission of monetary policy
“At our upcoming meetings, further normalization of interest rates will be appropriate,” said ECB chief Christine Lagarde. The ECB justified the bigger hike by an “updated assessment of inflation risks” and pledged further action possibly as soon as its next meeting in September. US government’s new Central Bank Digital Currency is a fast track to digital concentration camps. The European Central Bank is right not to over-react to recent banking problems.
For example, Heider, Saidi and Schepens show that the introduction of negative policy rates by the ECB induced high-deposit banks to incur more risk by lending to borrowers with a larger return-on-assets variation than low-deposit banks . But even though the borrowers of high-deposit banks show a higher volatility of returns, they exhibit lower levels of leverage and the same level of profitability as the borrowers of low-deposit banks. Studies document that a surprise hike in the policy rate has a negative effect on banks’ stock prices in normal times, but a positive effect in an environment of negative policy rates, which is increasing in the dependence of banks on deposits as a source of funding .
The introduction of negative policy rates allowed the constellation of rates to expand into negative territory. As the expansion of the interest rate distribution on the negative side affects not only current rates but also expected future rates, the stimulus also propagates to longer maturities . Composite funding costs for euro area banks have been compressed since 2014, helping to maintain intermediation margins for banks with an average funding structure.
This “hot potato effect” also extends to bank loans, which was the second objective of lowering rates into negative territory. With the start of negative rates, we have observed a steady increase in the growth rate of loans extended by euro area monetary financial institutions . Central banks have responded in different ways to the fall in equilibrium rates. As the global financial crisis broke and conventional policy space was exhausted, most central banks resorted to forward guidance as a means to provide additional accommodation. At the same time, like with other unconventional policy measures, side effects are likely to increase over time, if the negative interest rate environment were to persist for too long.
Within the euro area, this primarily applies to Germany, Luxembourg and the Netherlands . As the market started repricing the full expected future interest rate path, the effects of the cut in the DFR extended well beyond short-term rates. A decomposition analysis by ECB staff shows that the NIRP contributed to shifting euro area sovereign yields downwards across the full maturity spectrum, with a peak around the five-year segment . The ECB is the first major central bank to introduce negative interest rates. Even if the current inflationary bout means it could be a while before Europe’s central bankers need to use negative rates again, it is unlikely they will want to rule them out. But higher borrowing costs could also spell trouble for heavily indebted countries like Italy or Spain.
The order of the observations does not have an impact on the outcome of the analysis . Et al., “The impact of negative interest rates on banks and firms”, op. cit. Chart 1 illustrates the declining trend in loan-to-deposit margins for new loans. Analogously, by granting loans or investing in securities with fixed rates and long maturities in the current environment, banks are locking in low income streams for a long period of time, which could adversely affect their profitability in the future. The stimulus to the broader economy provided by NIRP has been effective in inducing an easing of financing conditions and thereby, ultimately, contributing to price stability.
With the exercise now abandoned in the face of galloping inflation brought on by pandemic and the Ukraine war, doubts linger over its effectiveness and under what circumstances it will ever be used again. Simply log into Settings & Account and select “Cancel” on the right-hand side. For cost savings, you can change your plan at any time online in the “Settings & Account” section.
The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem. The interest rate on the main refinancing operations , which provide the bulk of liquidity to the banking system. While such a policy is widely considered valid only for economies in Europe and Japan with chronically low inflation and weak growth, the idea is attracting other supporters elsewhere – not least U.S. President Donald Trump, who has labeled U.S. central bankers “boneheads” for not resorting to it.
This conclusion is based on an assessment of the impact of NIRP on bank profitability across bank business models using a dynamic macroeconomic model similar to that described above. An ECB meta-analysis of various studies corroborates the view that the use of the NIRP had a positive impact on loan growth. The analysis shows that, since the start of the NIRP regime in mid-2014, the growth of loans extended to non-financial corporations would have been lower in the vast majority of counterfactual scenarios of non-negative policy rates . In addition, several empirical studies exploiting bank-level data confirmed the causal link between negative policy rates and loan growth. There are also limits to how deep central banks can push rates into negative territory – depositors can avoid being charged negative rates on their bank deposits by choosing to store actual banknotes instead. Third, commercial banks are encouraged to expand lending to avoid negative interest on their holdings of excess liquidity.
For instance, one important channel leading to improvement at the macro level is that the banks’ loss of interest margins represents a gain for households and corporations through cheaper borrowing, while the rate on deposits does not fall as much. But rate cuts in negative territory do not seem to amplify this negative impact on banks’ margins in a significant way. In a paper for the European Parliament, we looked in detail at the possible effects and side effects of the ECB’s NIRP. Here, we focus on the transmission of the negative policy rate to bank rates. This is important because a compression of the spread between credit and deposit rates would reduce banks’ net interest margins and possibly their profitability. In addition, two additional policy measures by the ECB have actively contributed to mitigating the impact of negative rates on bank profitability with a view to protecting the bank lending channel.
The transmission of negative interest rates
Conversely, weaker banks with limited capacity to expand credit supply or increase risk may keep lending rates unchanged or even be forced to increase them. This has been referred to in the economic literature as the “reversal rate”. Other studies focus on the weight of liquid assets in banks’ balance sheets or the self-reported impact of the policy on banks. For each study and each key characteristic, we compute the growth of bank loans to firms that would have emerged if the ECB had not adopted NIRP in 2014. We then order these counterfactuals depending on the resulting loan growth, and report their median and their overall range , spanning values from just above the actual loan growth to well below it.
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The COVID crisis hit Italy early, and contributed to an increase in yields on Italian government debt . Through the PEPP, the ECB aimed, in part, to reduce this widening spread. While the bond purchases do reduce government borrowing costs, ECB officials have said that the asset purchases are aimed at preventing destabilizing runs on government bonds and ensuring that easy monetary policy gets shared equally across the eurozone. Rarely does monetary policy generate as much sound and fury as did the recourse in the early 2010s to negative rates by four European central banks and the Bank of Japan – now the only monetary authority still sticking with them. The bank’s previous policy of negative deposit rates effectively penalizes banks for parking money with the ECB overnight. It was aimed to encourage more lending and, therefore, more economic activity, which can also contribute to inflation.