The prolonged period of negative interest rates in the euro area and other advanced economies has raised concerns that a further monetary policy accommodation could entail the opposite effect than what is intended. Specifically, there is a risk that a further monetary policy loosening in negative territory might produce contractionary effects. The policy rate enters a ‘reversal interest rate’ territory, to use the terminology of Brunnermeier and Koby (2018), in which the usual monetary transmission mechanism through the banking sector breaks down.
A key feature in understanding the potential threat of a reversal rate is the transmission of policy rates to other interest rates (Altavilla et al. 2019, Eggertsson and Summers 2019, Erikson and Vestin 2019). There is growing evidence that the pass-through of policy rates to banks’ deposit rates is increasingly imperfect for negative rates due to banks’ reluctance to lower rates below zero (e.g. Eggertsson et al. 2019, Heider et al. 2019). At the same time, the return of liquid assets of banks, such as reserves and government assets, falls with a policy rate cut. This lowers bank profitability with negative implications for credit supply, as also discussed in Brei et al. (2020).
This highlights an important trade-off for monetary policy in a low interest rate environment, in which the central bank needs to balance inflation stabilisation and the effectiveness of the monetary policy transmission through the banking sector. In a recent paper (Darracq Pariès et al. 2020a), we develop a new nonlinear macroeconomic model with a banking sector fitted to the euro area economy that captures this trade-off and features an endogenously determined reversal interest rate.
We demonstrate that the probability of encountering the reversal rate depends on the capitalisation of the banking sector. As a consequence, the possibility of the reversal rate creates a new motive for macroprudential policy. Building up macroprudential policy space in good times to support the bank lending channel of monetary policy, for instance in the form of a countercyclical capital buffer (CCyB), mitigates the risk of monetary policy hitting a reversal rate territory, or alleviates the negative implications if it does.
Monetary policy may be transmitted in non-linear ways when interest rates are low
We develop a new non-linear macroeconomic model that captures the outlined stylised facts and demonstrate the conditions where such a reversal rate could materialise. The framework is a New Keynesian model with a banking sector that is calibrated to salient features of the euro area economy for the current low-rate environment.
The banking sector contains three key features. First, banks are assumed to be capital constrained, giving rise to financial accelerator effects based on Gertler and Karadi (2011). Second, banks have market power in setting the deposit rate. However, while banks’ market power is strong in good times, it weakens if the policy rate approaches a negative environment, as in Brunnermeier and Koby (2018). This captures the increasingly imperfect pass-through of policy rates to banks’ deposit rates for low rates. Third, banks are required to hold low-risk, liquid assets for a proportion of their funding based on reserve requirements and regulatory constraints, similar to Eggertsson et al. (2019).
These features give rise to non-linear effects of economic shocks and monetary policy responses, depending on the initial state of the economy and the level of interest rates. If the economy is in a vulnerable state of weak growth and monetary policy rates are close to the zero lower bound, a demand shock to the economy (here assumed to be a shock to risk premia) can have non-linear, asymmetric effects owing to the fact that monetary policy loses some of its effectiveness. Figure 1 illustrates that in such a situation the negative economic effects of a large contractionary risk premium shock (two standard deviations) are much more severe than the effects of small contractionary risk premium shock (one standard deviation).
Figure 1 Impulse response functions of risk premium shocks
Notes: This figure presents impulse response functions of risk premium shocks that differ in size. One (blue solid) and two (red dashed) standard deviation increase. The economy is initially at the (risky) steady state.
Economic intuition would suggest that an increase in risk premia, which is a contractionary shock, affects the consumption and savings decisions of households as well as the refinancing costs of banks. Households postpone consumption, so output drops. This affects banks, as their return on assets is lower and asset prices fall. In addition, the funding costs of banks increase. Both effects reduce the net worth and weaken the balance sheets of banks, which amplifies the shock via the financial accelerator mechanism. In response, the central bank lowers the nominal interest rate to mitigate the economic downturn. However, the impact of such a policy is non-linear, owing to the imperfect deposit rate pass-through and the lower return on government asset holdings.
The reversal interest rate as effective lower bound for monetary policy
At very low or negative interest rate levels, monetary policy becomes less effective as shown and can even enter a ‘reversal interest rate’ territory in which a marginal monetary policy accommodation produces contractionary effects. This is depicted in Figure 2, which shows declining welfare for more negative lower bounds (blue line).
Figure 2 Welfare, lower bound, and macroprudential policy
Notes: This figure presents the welfare of the agents in the economy without (blue solid) and with (red dashed) macroprudential policy for different lower bounds on monetary policy R^A.
This suggests that a very negative lower bound can result in counterproductive outcomes as the reduced profit of banks is not offset by the diminishing deposit rate pass-through. At the same time, an overly restrictive lower bound such as keeping the policy rate at positive levels lowers welfare as the central bank forgoes potentially beneficial monetary accommodation.
Pre-emptively creating macroprudential policy space can safeguard against the reversal interest rate
As banking sector capitalisation plays a key role in the occurrence of the reversal rate, we incorporate macroprudential policy in the form of a countercyclical capital buffer rule that can impose additional capital requirements. The Basel Committee on Banking Supervision prescribes that the buffer is built up during a phase of credit expansion and can then subsequently be released during a downturn.
We demonstrate that such a macroprudential policy rule can lower the probability of hitting the reversal interest rate. The banking sector builds up additional equity in good times, which can then be released during a recession. Having accumulated additional capital buffers during good times, the negative impact on the banks' balance sheets of a reduction of monetary policy rates is dampened. Consequently, monetary policy becomes more effective during economic downturns and the reversal interest rate is less likely to materialise for states of low interest rates, which improves overall welfare.
The positive impact of macroprudential policy is illustrated in Figure 2, where welfare with an active macroprudential policy is shown (red line). Welfare is now considerably higher as the central bank is less likely to enter reversal interest rate territory. In fact, the optimal capital buffer rule reduces the probability to be at or close to the ‘tipping point’ by more than 25%. It also lowers the frequency of negative rates and economic fluctuations. This illustrates that macroprudential policy can be a crucial tool in repairing the bank lending channel of monetary policy in a low interest rate environment.
In related work (Darracq Paries et al. 2020b), we show that the availability of larger releasable buffers before the Covid-19 crisis would have provided an important complement to the monetary policy mix. Counterfactual simulations show that the crisis response could have been enhanced if authorities had built up more macroprudential space. This could have shielded economic activity better and complemented monetary policy accommodation more effectively.
Conclusion
The analysis has at least two important policy implications. First, macroprudential policy using a countercyclical capital buffer approach has the potential to alleviate and mitigate the risks of entering a reversal rate territory. Second, there are important strategic complementarities between monetary policy and a countercyclical capital-based macroprudential policy in the sense that the latter can help facilitate the effectiveness of monetary policy, even in periods of ultra-low, or even negative, interest rates.
Author’s Note: This column represents the views of the authors and not necessarily those of the European Central Bank, the Bundesbank or the Eurosystem.
References
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