Negative interest rates: transmission on private deposits and implications for the consumers

Background and current status

           Due to its apparent empirical implausibility, economic research has often neglected the study of negative nominal interest rates. Withstanding of negative nominal interest rate, consumers will be encouraged in holding more monetary assets than bank deposits (Abo-Zaid and Garín, 2015). Therefore, demand for monetary assets increases, at the expenses of non monetary assets. In detail:

                Md/P = L(R,Y)

?   Holding Price levels and Income constant, we expect an increase in demand for monetary assets to be caused by a decrease in interest rates.

Nevertheless, the theory and knowledge in the conditions of a negative R are still limited. Theoretically, a negative R is expected to boost money demand even further. In current status of no Inflation in Europe, negative interest rates translate into negative nominal interest rates (Abo-Zaid and Garín, 2015). However, since negative rates are transmitted to financial institutions holding people’s liquidity and monetary assets, the negative rates pass on clients deposits. Therefore, also monetary assets[1] are not shielded from negative interest rates anymore. 

In detail, some central banks in Europe, specifically the European Central Bank, Danish, Swiss and Swedish central banks, have recently moved to negative deposit interest rates. For Denmark, Switzerland and Sweden, the exchange rate against the euro proves to be crucial for their economies. To contain their currencies, central banks have to offer interest rates that are below the ECB's. The deposit rate in Switzerland and Denmark is -0.75%. In Sweden it is -1.1% (The Economist, 2015). Nevertheless, commercial banks did not swap their reserves to central banks. Therefore, it is interesting to investigate what happens when negative rates are passed on broadly to consumers.

From Commercial Banks to Consumers

            In theory, the negative rates would induce people to spend their money or keep it in cash, rather than save and watch deposits shrinking in a bank account. At this stage, householders’ marginal utility from further money holdings can be regarded close to zero and real money demand may, de facto, not increase with further lower (negative) interest rates. Rognlie (2015) elaborated this mechanism as follows:

 v′(Md(i, c)) = iu′(c)

With:

v(m(t)): v(m(t)) utility from real cash balances m(t) into household preferences

i: the nominal rate on bonds, corresponding to the opportunity cost of holding bonds rather than cash

 Md(i,c): real cash demand as a function of nominal interest rates i and consumption c

           However, the transmission of negative interest rates to consumers is not a granted or immediate fact. Hence, in the short-term from negative interest rates implementation the real effect on consumer is rather weak. In detail, commercial banks would ponder carefully the consequences before passing negative interest rates to their clients. As long as interest rates and lending rates decrease, the impact will not be significant in the short-term. However, such development does not prove to be sustainable for commercial banks in the long-term. Lending rates are expected to follow the policy rate, moving the profitability of the banks under pressure. When profitability will be eroded at unsustainable level, it can be supposed deposit and lending rates to fall below zero in effort to reinstate the profitability. Such fact already happened in some European banks.

In early 2016, Alternative Bank Schweiz AG became the first Swiss bank to impose negative interest rates systematically on its customers. Violating an almost holy principle in the financial world, the bank started to charge 0.125% per annum to all its clients in order to maintain their accounts at the bank during the year (Letzig, 2016).

The move to charge clients was motivated by the Swiss National Bank's shift to negative rates in late 2014. The central bank rate was held at minus 0.75% but it is expected to be pushed lower given Swiss franc’s appreciation (Letzig, 2016).

 Moreover, German cooperative savings banks Gmund and Skatbank implemented such policies previously. Gmund cooperative bank deducts 0.4 percent the savings in excess of 100,000 euros, while Skatbank applies the same rate for deposits over 400,000 euros (Shotter, 2015).

Furthermore, negative rates had an impact on pension payouts also, offering older savers further reason to swell their cash savings. Pension funds and retirees usually invest in government bonds, seeking for safe income. Now pensioners are forced to save more for their retirement and, due to the slow and uncertain economic recovery in Europe, propensity to consume does not increase as expected. As the graph below shows, savings rate as percentage of income has actually soared in countries since the implementation of negative interest rates, in comparison to Eurozone where it did not experience significant variations (OECD, 2016).

Similarly, the gross household savings rates manifested an increase since the central banks switched to negative interest rates. Notably, in Denmark more than doubled from January 2015 to July 2016 (Eurostat data).

Nevertheless, household spending as a percentage of gross domestic product has reduced slightly in Germany to 53.94% in 2015 from 55.4% in 2013, according to OECD data. In the same timeframe, it also has fallen by 1.5% in Sweden and has not varied consistently in Denmark and Switzerland (OECD, 2016).

           Ultimately, the effect on consumption depends on householders behaviour. If savings rate was unchanged, the impact of negative interest rates on deposits would be not different from a proportional cut when rates are positive (Jackson, 2015). However, if consumers walk away from deposits and pile up into cash in order to avoid negative deposit rates, a decrease in current deposits would hit banks’ loanable funds and suppress the stimulative effect of negative rates (Jackson, 2015). In addition, in such context, the modality and cost of moving into cash from deposits, will influence depositor behaviour. Expectations on the commitment in keeping negative interest rates polices by central banks may also condition the demand for cash.

Theoretical explanations

Theoretically, expansionary monetary policies are expected to raise the money available and, consequentially, to have positive impact on the financial markets. Rising price stocks imply an higher value of household wealth, thereby an increase in financial resources and, therefore, consumption (Mishkin, 2001). The mechanism can be explained as follows:  

Ando and Modigliani (1963) explained such phenomena as the standard life-cycle of wealth. The lower interest rates, the lower the discount rate applied to flows associated with stocks, real estate, and other assets, pushing up their price.

Empirically, the passage from increase in wealth W and consumption C proves to be weak in the current conditions. In detail, Catte and others (2004) discovered that the long-run marginal propensity to consume originated from financial wealth varies from 0.01 in Italy to 0.07 percent in Japan. Similarly, the value for the United States is 0.03 and the value for OECD countries is 0.035. Therefore, the short-run financial wealth impact on m.p.c. are even smaller, and monetary policies can only influence wealth negligibly. Consequentially, the financial wealth effect has an important role in macroeconomic models, but had a secondary impact in translating interest rate easing into actual consumption (Catte and others, 2004).

The Swedish case

           So far, in Sweden, the deposit and lending rates have not followed the central bank rate into negative territory, notwithstanding the considerable rate of -1.1 %. The interest rates on private deposits also seems to accompany the central bank rate closely, with correlations close to one (see Table below). Nevertheless, a change in trend arises in conjunction with the Swedish central bank to switch into negative waters (2015). In detail, the difference between the repo rate and the deposit rate narrowed, reaching a point in which the deposit rate overcame the repo rate (Fransson and Tysklind, 2016). Mainly because commercial banks held back from imposing negative deposit rates.

Moreover, the covariation between the central bank interest rate and the longer market rates is less strong than shorter rates. In longer maturities, variables as maturity premiums, expectations of the future interest rates and the trend of financial markets (Alsterlind and others, 2015). Arguably, if such condition of negative interest rates will prolong in the long-term, commercial banks would probably switch towards imposing negative interest on private deposit accounts. This, would imply that also lending rates are trimmed further (Alsterlind and others, 2015). 

           Nevertheless, Swedish commercial banks have therefore chosen not to pass the negative rates on to their customers’ deposit accounts (yet). As the figure below shows, the lending rate has been following the central bank’s Repo rate while the deposit rate has remained stable around zero. What drags Swedish commercial banks from charging negative interest rates? Mainly, confidence in the current economy status and in the financial sector. As Franzen (2016) supports, in Sweden currently corporate optimism and household confidence in economic policy are weak and this repress demand and contribute towards sinking consumption. As the figure below shows, private consumption plummeted trough the last 20 years. Moreover, as shown previously, in Sweden saving rate has never been higher than their current stage. Therefore, business and householders are hindered from investing and pouring their money in the financial market, without making banking sector shifting away from its current paralysis (Fransson and Tysklind, 2016).

Long-term implications on householders and economy

           Negative interest rates could be a short-term solution to adverse economic conditions. However, if prolonged excessively, can even worsen the economic conditions. On the basis of the assumptions underlined previously, this section summarises the evidence for the dangers posed on householders and consumers by ultra-expansionary monetary policies.

A- Savings boost, consumption reduction

On one hand, negative interest rates act as a stimulus to save less and consume. Moreover, negative interest rates and increase in money supply have positive effect on aggregate demand, as investors may switch preferences from owning financial assets to other assets, increasing their prices.

On the other hand, negative interest rates cut future income and total lifetime income. This fact, prompt a stimulus to increase the savings in order to compensate such loss (Palley, 2016). Moreover, a negative interest on private deposits can be regarded as a form of tax that shrink wealth. Therefore, such mechanism can reduce consumption spending and aggregate demand.

Consequentially, the theoretical effect of negative interest rates on consumption is unclear. However, the empirical evidence gained in Sweden and Denmark seems to opt for the second option.

B- Banking system disruption

           As most of banks profit come from lending activities, negative interest rates have drastic effect on their balance sheet. In detail, top six global banks witnessed their profit from commercial and lending divisions to squeeze on average by about 45% in 2015 (See picture below). Moreover, forecasts for 2016 do not draw a better scenario (Financial Times, 2016). Therefore, given the weakened balance sheets, commercial banks may actually be less prone to lend money to householders, that is exactly the opposite aim wished by central banks when implementing expansive monetary policies. Moreover, when negative interest rates are passed on private accounts, depositors have a reason to cut money holdings to avoid their money shrinking. Hence, margins from investment management may face a hit, pushing banks profitability further down.

In Europe, plummeting banks profits is creating turmoil in financial markets, but also political sphere. In a environment with more than 1 trillion of non performing loans overhanging commercial lenders, the banking system is already in precarious shape (Directorate for internal policies, economy unit, 2015). Record-low interest rates did not help either to recover such lump sum and, eventually, proved to be a further concern for banks.

The main implication for european householders and savers is the new regulation on banking rescue, the so called “Bail-in”. As The Economist (2013) explains, Bail-in consists in rescuing a financial institution at the threshold of default by making its creditors and depositors bear the loss on their holdings. Therefore, no government or third parties are involved and account holders will face the default costs on their own shoulders, seeing their bond holdings and amount exceeding €100,000 to be scrapped to rescue the bank. In a current environment of plummeting profits and management mispractices, the perspective of banking defaults borne on savers’ accounts surely does not help in restoring consumer confidence.

C- Asset price bubbles

House purchases are mainly financed with mortgages, and low interest rates therefore lead prices to climb by reducing mortgage payments and increased affordability. Hence, ordinary risk adverse householders may be attracted by the appealing interest rates, and then venture new, possibly risky, investments (Palley, 2016). Moreover, investors are induced to underweight holdings of money and bonds, and to pile up holdings of riskier assets or different silos chasing new profit gain that fixed income does not provide anymore (Palley, 2016). Both of these actions inflate asset prices.

           Overall, negative interest rates policies neglect the possibility that such rates may reduce aggregate demand, causing financial instability, increase savings rates, generating asset bubble and foster a climate of uncertainty that surely does not feed up consumer confidence. Above all, negative interest rates maintains and lift a doped growth, dragged exclusively by unconventional monetary dives that encouraged stocking up on debt and foster asset price inflation, which has already a caused a financial crisis in the last decade.

References

Abo-Zaid, S. and Garín, J. (2015). OPTIMAL MONETARY POLICY AND IMPERFECT FINANCIAL MARKETS: A CASE FOR NEGATIVE NOMINAL INTEREST RATES?. Econ Inq, 54(1), pp.215-228.

Alsterlind, J., Armelius H., Forsman D., J?nsson B., and Wretman A. (2015). How far can the repo rate be cut?. Sveriges riksbank economic review. Available at: https://www.riksbank.se/Documents/Rapporter/Ekonomiska_kommentarer/2015/rap_ek_kom_nr11_150929_eng.pdf [Accessed 24 Sep. 2016].

Ando, A., and Modigliani F. "The "Life Cycle" Hypothesis of Saving: Aggregate Implications and Tests." The American Economic Review 53.1 (1963): 55-84.

Catte, P., N. Girouard, R. Price and C. Andre (2004), ‘Housing markets, wealth and the business cycle’, OECD Economics Department Working Papers.

European union: Directorate for internal policies, economy unit, (2015). Non-performing loans in the Banking Union: stocktaking and challenges.

Fransson, L. and TyskLind, O. (2016). The effects of monetary policy on interest rates. Sveriges riksbank economic review, 1(2).

Franzen, T. (2014). Does the capital market create problems for the economy?. Sveriges riksbank economic review, 1(3).

Jackson, H. (2015). The International Experience with Negative Policy Rates. Canadian Economic Analysis, Bank of Canada.

Jones, C. (2016). Draghi turns blame on bankers for their weak profits. The Financial Times.

Letzig, J. (2016). Negative Rates Upend the World --- A Swiss bank enters uncharted territory, and signs are positive. The Wall Street Journal.

Mishkin, F. (2001). THE TRANSMISSION MECHANISM AND THE ROLE OF ASSET PRICES IN MONETARY POLICY. NATIONAL BUREAU OF ECONOMIC RESEARCH, Working Paper 8617.

OECD (2016), Household savings forecast (indicator). doi: 10.1787/6ab4e1bd-en (Accessed on 11 September 2016)

OECD (2016), Household spending (indicator). doi: 10.1787/b5f46047-en (Accessed on 12 September 2016)

Palley, T. (2016). Why Negative Interest Rate Policy (NIRP) is Ineffective and Dangerous. Institute for Macroeconomics.

Rognlie, M. (2015). What Lower Bound? Monetary Policy with Negative Interest Rates. Job Market Paper, MIT Press.

Shotter, J. (2015). German bank charges negative rates on large deposits. Financial Times.

The Economist, (2015, Nov 28th). Bankers vs mattresses; Negative interest rates.

The Economist, (2013, April 7th). What is a bail-in?

 

[1] Monetary assets currently deposited in commercial banks.

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