Negative interest rates elicit negative reactions

IN their struggle to keep up the momentum of economic growth, central banks are turning to negative interest rate policy (NIRP) as their weapon of choice. Amid doubts about the impact of further large- scale asset purchases, the Bank of Japan (BOJ) has recently followed the European Central Bank (ECB) and other European counterparts in imposing negative rates on the reserves that banks hold with them. Meanwhile, weak economic data has even prompted talk of the Federal Reserve potentially having to reverse course and join the NIRP club.

But there are doubts about NIRP too. In particular, if banks resist passing on negative rates for fear of triggering a deposit flight, they will fail to incentivise savers to spend. NIRP could still work via boosting asset prices or driving down the exchange rate, but, as the BOJ has discovered, this is a confidence trick that is liable to succumb to the vagaries of financial market sentiment.

So are the banks right to fear the zero lower bound (ZLB)? The obvious problem is that we have no experience to go on, since no bank has been brave enough to breach it in a significant way. The banks are clearly concerned that cutting savings rates below zero would lead to a customer backlash and significant withdrawals of deposits. But with loan rates often contractually linked to money market rates, shielding savers from lower rates comes at the cost of bank profitability, capital generation and willingness to lend. This, in turn, blunts the intended stimulus that the central banks are trying to deliver by lowering rates.