How does one explain how central banks are able to stimulate the economy by setting negative central bank interest rates?  In a new study, to be presented at the Royal Economic Society annual conference in April 2019, Oliver de Groot and Alexander Haas develop a “signalling” theory to illuminate how negative interests actually work.

Several central banks across the world (in Denmark, the Euro area, Japan, Sweden and Switzerland) have dipped their toes into negative interest rate waters in recent years in an attempt to provide additional stimulus for their ailing economies – an experiment never attempted prior to 2014. In the Euro area, for example, the European Central Bank’s deposit facility rate (the interest rate European banks earn on reserves held at the central bank) currently stands at negative 0.4%.

There is good reason why one might question the usefulness of negative interest rates. Empirical evidence shows that retail banks have been reluctant to pass on negative central bank interest rates to customers, choosing instead to leave households earning at least zero percent on their deposits. The fact that banks haven’t passed these negative interest rate on to their customers, however, means that banks’ net interest margins have shrunk. This hurts bank profitability, potentially curbing lending supply and thus hampering economic activity. And without a change in the interest rates earned by household or faced by firms, there is also no boost in consumption or investment demand from negative interest rates.

However, the authors show that this explanation is incomplete because it ignores the role of expectations. By building a dynamic, general equilibrium macroeconomic model of the economy, they show that the effectiveness of negative interest rates rests on what current policy signals about future policy. An extremely robust finding in decades of academic monetary policy research is that central banks adjust policy gradually. This suggests that if policy rates are lowered today then policy rates will also be lower in the future. And even though market interest rates (such as deposit rates) will not be lowered today by banks, the negative interest rates signal to households that deposit rates will rise more gradually in the future, inducing consumers and households to still bring forward spending decisions to today and boost consumption demand.

In addition, banks, rather than experiencing falling profits and contracting lending as hypothesised in the theory without signalling, experience the opposite. Rising consumption demand raises the value of banks’ assets, and via the financial accelerator theory developed by Ben Bernanke and co-authors, lowers the spreads between deposit rates and lending rates. With lending rates lower, firms’ investment demand also increases, positively amplifying the effect of negative interest rates on economic activity.

The authors study shows how the contractionary net interest margin channel and the expansionary signalling channel interact. One important finding is that negative rates are less effective when the banking system is awash with excess reserves. However, despite large quantities of excess reserves in both the US and Europe’s banking systems, a quantitative assessment of the authors’ model concludes that the signalling channel still dominates, and that negative rates should have expansionary effects in both economies.

The study ends by assessing the role of negative rates when a central bank can set policy optimally. They show that setting a negative rate would either be redundant or harmful in two extreme scenarios, i) in which the central bank could perfectly and credibly commit to future policy and ii) in which it could not commit to any future actions at all. They find that negative interests are only a part of the optimal monetary policy toolkit in the intermediate case in which the central bank can only partially commit to future actions. This intermediate case, however, is a pretty reasonable description of how central banks operate in the real world.

They conclude that the signalling channel of negative rates operates in a similar fashion to central banks’ “forward guidance” policies. The crucial difference is that the effectiveness of forward guidance relies on a verbal promise (e.g. the central bank will slow down future interest rate hikes) that people may struggle to believe. Negative rates, however, works on a near universal truth of monetary policy, that when a central bank actually lowers its policy rate, it is usually slow in raising it again.  

  “The Signalling Channel of Negative Interest Rates” by Oliver de Groot and Alexander Haas, Mimeo 2018.

Oliver de Groot

University of Liverpool Management School

Alexander Haas

DIW Berlin