The Effects of Negative Interest Rate Policies

In the autumn of 2014, Denmark and Sweden took deposit rates back into negative territory, and at the beginning of 2015, Denmark, Sweden and Switzerland also cut their target policy rates below zero. As Figure 1 suggests, most of the small economies that applied a negative interest rate policy (NIRP) intended to fend off "excessive" capital inflows and weaken their currencies. In large economies – such as Japan and the Eurozone – NIRPs were regarded as a complement to the quantitative easing (QE) policies with the intention of stimulating credit creation and thereby boosting growth while reducing deflation risks.

NIRPs Have Translated into Lower Market Interest Rates

In order for a NIRP to have an effect on aggregate demand or the exchange rate, the lowering of rates from positive into negative territory would need to affect the interest rates determined in financial markets. Indeed, in all examined markets, the 2-year swap rate (a market determined interest rate) has moved in sync with the respective central bank policy rate. The relationship holds just as clearly whether the policy rate is in positive or negative territory.

A number of macroeconomic variables likely to be highly sensitive to interest rates, particularly credit growth, construction spending and house prices, have also been examined. In general, there wasn't a significant difference in patterns between countries with or without a NIRP. Similarly, there wasn't a change of trend in countries as their policies moved from positive interest rates to negative rates. For example, consumer credit accelerated from 2015 to 2016 in Denmark, while slowing in Sweden during the same period. House prices surged in Sweden, grew strongly in Denmark and decelerated in Switzerland from 2015 to 2016, while construction slowed in Denmark and remained strong in Sweden. This suggests that country-specific cyclical factors other than NIRPs dominated the dynamics in these markets.

Surprisingly Limited Effects on Exchange Rates

At first glance, the central banks which implemented NIRPs to weaken their countries' currencies do not seem to have been successful in doing so. The EUR/CHF exchange rate was largely invariant to changes in the interest rate spread between the euro and the Swiss franc in the past three to four years. The likely reason for the lack of response of the EUR/CHF exchange rate to the NIRP is the continued "safe-haven" effect, which boosted the value of the franc. Moreover, the absolute interest rate spread may simply have been too narrow to have an effect. And, finally, markets may have assumed that the franc was to a large degree pegged to the euro even after the abandonment of the SNB's lower bound for EUR/CHF – which then led to an "anchoring" of the exchange rate at that level.

Interestingly, our analysis shows that large central banks seem to be more successful in achieving their currency targets through interest rate policies (including NIRPs) than small central banks. It is notable that the Bank of Japan, in particular, had far greater success in weakening the yen against the US dollar since it moved to unconventional policies, including negative interest rates, after the financial crisis. The same applies to the European Central Bank.

Contractionary Effects of NIRPs?

The evidence presented above suggests that the effects of NIRPs are in principle no different from those of conventional interest rates policies. The question is whether the negativity of rates may have some qualitatively different effects. The obvious contractionary effect that could result from implementing a NIRP is a flight into cash.

The evidence of the past years suggests that there has been an increase in the demand for cash in some countries as interest rates declined. In Switzerland, bank notes in circulation increased in the months that followed the introduction of the NIRP and the amount remains elevated in both a historical and international comparison. In Japan, cash holdings have also risen, but this trend was already in place before negative interest rates were introduced. Legal changes seem to have boosted holdings additionally along the way. In other economies such as Sweden, the trend has been toward lower cash holdings despite declining interest rates – as more efficient, electronic transaction technology outweighed the lower opportunity costs of holding cash.

A second potentially contractionary effect of NIRPs relates to their possible effect on bank profitability, even when a flight to cash does not occur. Given banks' inability to pass on negative rates to depositors, or if they cannot maintain bank lending rates at levels sufficient enough to safeguard a normal rate of profit, their ability to lend could decline. Taking interest rates into significantly negative territory could then lead to a contraction in bank lending and thus a slowing of economic growth, as well as higher deflation risks. Moreover, if banks' balance sheets are weakened because of NIRPs, banks might switch from riskier assets (such as loans) into 'safer' assets such as bonds and thereby exacerbate the credit crunch and economic downturn. Once again, these negative effects from NIRPs have not – to date – been observed in the respective countries.

Do NIRPs Have a Future?

The general conclusion is that NIRPs, at least so far, do not seem to have markedly different effects on the economy from those expected during periods of conventional policy easing. That said, the extent of NIRPs in terms of the level of (negative) rates and the breadth of the policies' application has been very limited so far.

The key question for the future is whether NIRPs could be applied more broadly should another economic downturn set in. The answer will likely depend on whether other policy tools will be at the disposal of central banks and whether these will prove more effective. The pursuit of QE in its current, non-fiscal form appears to be an inferior tool to NIRPs for the simple reason that the acquisition of ever larger volumes of financial assets by central banks and their simultaneous removal from private markets would essentially amount to a drying up of financial markets.

Small economies trying to reduce pressure on their currencies may find negative rates easier to implement than letting their central bank balance sheets expand due to large purchases of foreign bonds. On the other hand, larger economies – notably the Eurozone and Japan – currently seem to be losing confidence in the effectiveness of negative rates in addressing the problems of slow economic growth and low inflation.