In the aftermath of the 2007 global financial crisis, central banks across all major economies adopted a whole set of new “unconventional” tools to influence and stimulate the monetary and financial conditions. The primary reasons for this new strategy was that conventional policies became very limited in their usefulness in times of an economic crisis. There are four main unconventional policy measures- (I) Quantitative Easing: the introduction of new money into the money supply by the central bank,(ii) Helicopter Money : the concept of printing new currency and distributing it to the public to provide a stimulus to the economy, (iii) Forward Guidance: actively managing expectations of the future path of the policy rate to provide extra stimulus when rates have reached their perceived lower bound (interest rate), (iv) Negative Interest Rate Policy(NIRP): setting policy rates below zero in nominal terms, This essay emphasises at the theory, mechanisms and effects of forward guidance and NIRP as unconventional policy tools, followed by a discussion based on the evidence gathered so far on NIRP to judge whether it will be measure the BoE should adopt in light of the November 2016 BoE Inflation Report.
Forward Guidance(FG) vs Negative Interest Rates Policy (NIRP)
Forward Guidance refers to statements made by the central bank to influence market expectations about future policy rate path. The Central bank views Forward guidance as a means of maintaining transparency and clarifying their intentions to provide some certainty about the current and future state of the economy. FG is widely accepted and implemented in all major economies in the world. It does not have a direct effect on the economy as the Central bank does not consider the announcements as a pre-commitment for future policy.
At present 5 economies have chartered into the previously unknown territory of negative rates, these are the European Central Bank(ECB), Bank of Japan(BoJ) and the central banks of Switzerland, Denmark, & Sweden. The measure previously considered unimaginable, the Negative interest rate policy is the most recent unconventional policy measure being adopted by economies. While NIRP is the defined as setting the policy rate below zero. The theory of NIRP aims at stimulating the growth in the economy through increased lending and encouraging spending by consumers on the other hand, has a direct impact on the economy and can be an extremely dangerous policy if not managed carefully.
The principle is that economic activity is liked with long term interest rates, and hence long term interest rates can be influenced by current and expected future policy rates. The central bank directly controls the base rates, in normal economic conditions a change in the base rate leads to a proportionate change in commercial bank rates. in times of a recession however these two rates diverge and lower base rates aren’t passed on to the consumers. In theory if the central bank announces that it is willing to keep interest rates low for a considerable period of time, the banks may be actually willing to cut the long term interest rates, which in turn will lead to increased overall lending the economy. This increase in lending should boost output and growth. FG can be used to manage inflation expectations and is also believed to have a positive effect on influencing the bond yield curve in the right direction. Clarity about monetary policy intentions leads to better outcomes because it lowers economic and financial uncertainty and so helps individuals to make better-informed decisions as well as enhance effectiveness of the current degree of monetary policy stimulus.(BOE 2013 A report by the Bank of Canada also believes FG to be an effective tool when communicated and perceived as credible.
In light of continuous decline of inflation and inflation expectations as well as short term policy rates approaching zero percent, it has become extremely difficult for monetary policy to influence real interest rates to its natural level which is consistent with stable inflation and potential output in the economy. Hence it was impossible for the real rates to fall further to help reduce the debt burden and support aggregate demand. It is argued that in such an environment, NIRP enhances the signalling capacity of the bank by effectively removing the Zero Lower Bound (Jobst and Lin 2016). In other words, decline in the nominal rate lowers the real rate component, allowing for a rise in inflation expectations and boost in aggregate demand. NIRP is effectively a charge that the central bank imposes on the commercial banks for deposit of money. Hence it no longer attractive for the banks to deposit its reserves with the central banks, instead forcing them to get rid of excess reserves. The banks do so by increasing interbank lending, leading to increased competition which pushes the overnight rate down and closer to the floor – deposit rate. The overnight rates push other rates down with it, specifically the interbank rate which influences other interest rates accessible to consumers. Hence it makes lending cheaper, which should lead to increased demand in loans and in turn provide an economic boost to the economy. The theory has been backed by some evidence of overall improvement in financial conditions and a modest expansion in credit in the Eurozone(Jobst and Lin).According to Bloomberg, Sweden & Denmark have experienced a degree of success , with Sweden recording a rise in inflation with property prices rising 25% y-o-y, while Denmark has used NIRP to drive away speculators , Danish bank earnings have reported to be in line with their European peers and prices per square meter having soared 43% between 2010 and end of 2015. . Another aim of NIRP is depreciation of currency, leading to increase in export volumes and hence through an indirect effect stimulate the economy. This is the very principle of Abenomics. However, findings in Japan have been mixed, with the yen actually appreciating, surging to an eighteen month high against the dollar(WSJ).
The reasons as to why FG hasn’t proved to be as effective as first thought may be guidance may not be understood or misinterpreted. FG can have a contradictory effect on economic sentiment offering hints might be interpreted as a sign that the CB is indirectly disclosing negative information about the risk to the economic outlook (Benoit Coeur 2013). The announcements made are often ambiguous in nature weakening the desired impact. It is almost impossible for central banks to guarantee the consistency of future decisions beyond the short term, hence even if understood it will be hard to believe. The market may not always agree with the central banks view of the outlook of the economy, which might undermine the credibility of the central bank and result in unwanted changes in the economy. As was showcased in the case of BoE, When Mark Carney first announced the FG, markets experienced a faster recovery than anticipated by BOE ,forcing BOE to act by raising future policy rates. BIS researchers have looked at the evidence form the US, UK, Eurozone and Japan, and concluded that while guidance helped to reduce the volatility of expectations about the future path of rates, it’s less clear whether they provide a meaningful economic stimulus. St. Louis Fed (2012) said “Overall, statistical analysis provides weak evidence that forward guidance increased the ability of market participants to forecast future short-term yields and no evidence of increased predictability of long-term yields. In a simulation to assess the effects of FG, Carlstrom et al (2012) find that there is a very strong impact on output and Inflation, a commitment to hold bank rate lower for even a couple of quarters can lead to an incredible rise in output & inflation. However, Empirical investigations of the effects of FG have been relatively limited, Moessner & Nelson (2008 on RBNZ) find that the effect of surprises in MP announcement on expectations is relatively small and that there is no evidence that deviations from prior forward guidance unsettle the market. Overall, the statistical analysis provides weak evidence that forward guidance increased the ability of market participants to forecast future short-term yields and no evidence of increased predictability of LT yields.
The criticism of NIRP is that as a result of this direct cost levied on the banks and in order to preserve their profitability, they may pass it on to the depositors, hence providing the depositors with an incentive to shift to cash, which will eventually deplete the banks resources severely and maybe causing the banks to lose some of their intermediation functions( Weale, BoE 2016). However in the EU and countries with negative deposit rates (Denmark, Sweden, Switzerland) there have been no clear signs of cash hoarding as current level of negative rates are not high enough to cover the opportunity cost of holding cash (Jobst and Lin,2016). The fact that retail customers have so far been shielded from the negative rates has played a key role in keeping demand for cash stable. Another major criticism is that NIRP may adversely impact on bank profitability, as they are heavily reliant on interest rates. Lower rates for a prolonged period of time, will decrease the net interest income. A flattening of the yield curve will result in the margin between lending and borrowing to compress reducing the net interest margin of the banks. The actual impact of negative rates on bank profitability is still uncertain. In the Eurozone banks have been able to maintain their lending margins. In cases where lending margins have been compressed, they have responded by shifting to a fee based system for their services or simply increased their lending volumes to offset decline in interest revenues (Jobst and Lin,2016) However, growth slower than before the global financial crisis. Evidence from Japan suggests that money markets haven’t experienced the expected increase in money markets, with banks having to search oversees for higher returns (WSJ 2016).
While FG has been adopted by the BoE, negative rates still remain very much in consideration with the MPC (bean 2013). However, the governor of BoE remains an extremely vocal critic who views the economic lower bound “as a positive number close to 0”. The evidence on the effectiveness of NIRP so far has been contradicting. In Eurozone, NIRP has not helped much against the fight against deflation, NIRP requires a strong banking sector to be effective, which has not been the case in the Eurozone, banks are under pressure in the Eurozone due to slow asset growth, economic uncertainty and rising nonperforming assts. Net interest income as a share of banks total income fell 58.7% in 2014 from 67.6% in 2008. Reserves are on the rise. Between Jun 2014 and Jan 2016, reserves have shot up more than 400%. Banks still prefer to hoard, even at a cost. In japan investments have been highly volatile, with yen actually appreciating, an effect opposite to what it is meant to do. A report by Riksbank states that companies and households will switch to cash overtime, rendering the central bank’s rate cuts ineffective.
The inflation report by the BoE suggests that ST economy is going to do better than LT, an increase in inflation to about 2.75%, it also suggests that depreciation might have a negative effect on the pound. There is great uncertainty surrounding the current environment in the UK following, the future trading relationship is unclear and could hinder investment. NIRP might further hinder growth and stability by putting further pressure on the bank balance sheets, with Barclays forecasting a £412 MN loss if base rates went negative. NatWest projects a significant increase in monthly fees for customers to offset the loss from such a move (telegraph). In his speech Martin Weale, believes that it is more likely that monetary tightening rather than easing will be needed in the UK and the current policy of asset purchases along with forward guidance has had a positive effect on the UK economy. In wake of the findings from the latest inflation report (BOE), I tend to agree with the view the existing policy program of QE along with guidance is optimal for the time being, most of the problems that NIRP addresses have been tackled in the latest forecast. It remains highly unclear as to where the NIRP will fit into the BoE policy arsenal and whether it is effective, as the evidence above suggests the results to be quite limited and mixed.