Eurozone sunken in muddy space of negative interest rates

The eurozone has sunk in the muddy waters of negative interest rates and quantitative easing without a way out in sight. The resentment of eurozone important players towards negative interest rate policy dates back to its introduction in 2014. It is only recently that we are seeing a push back against the prospect the central bank would deploy negative interest rates in the U.S A growing number of policymakers are now questioning the value of the European Central Bank (ECB) deep foray into unconventional monetary policy. Even the proponents of negative interest rates admit that this policy has important side effects. More worrisome is that the ECB seems to have become ineffective in achieving its targets and that economics prospects were not great even before COVID-19 pandemic.

In the wake of the 2008 financial crisis and the aftermath of 2010 debt crisis, a liquidity trap appeared in the euro zone, with interest rates set to zero and record amounts of money poured into the banking system. In 2014, as aggregate demand and inflation remained subdued the ECB started worrying about the trend of declining contribution of non-core inflation to the HICP inflation, as well as about the steepness of the short-term interest rate future curve. So, the ECB felt it needed to re-empower its monetary policy and free itself from the liquidity trap. Today, it is clear that the ECB has failed to achieve its stated goals after 6 years of deflation and further reductions in interest rates and quantitative easing. The inter-temporal substitution that is central in monetary policy has not worked well after a large and persistent shock.

It could be argued that negatives rates were just a continuation of the ECB’s monetary policy. Nominal interest rates have come down substantially also normal times, with a down secular trend in both nominal interest rates, real interest rates and inflation expectations since the eighties. Starting mid-nineties, the low bound became a constraint on monetary policy. And clearly since 2008, the lower bound constraint on monetary policy has been the norm. And, it is possible that the nominal interest rate is likely to continue hitting the lower very bound very often and every time the unemployment rate exceeds the natural unemployment rate by as little as 1 percentage point.

According a 2019 IMF study, the pass-through from wage growth to core inflation is significantly lower in periods of subdued inflation and better anchored inflation expectations, greater competitive pressures, and robust corporate profitability. These features were characteristics of the situation in the euro zone in the last decade. Now, it is unclear whether firms can increase prices in the midst of deflation. The weakening of the wages to inflation pass-through is one of many reasons why the ECB should be careful about conducting monetary policy that is based on outdated understanding of linkages between monetary policy and the real economy.

First, consumer price pressures have remained limited though wages have been rising faster than productivity in many European countries for the past few years, weakening the pass-through from wage growth to core inflation. The pass-through was estimated to be only two-thirds as strong as in the period before the 2008 financial crisis. Another IMF study has found that “the protracted period of low and below-target inflation in the euro area since 2013 has weakened their anchoring”.

Second, the euro zone has been facing major structural challenges and slow implementation of reforms that would be commensurate with the requirements of a robust and sustainable economic recovery. Since the financial crisis, the ECB has repeatedly at the same time called for strong fiscal policy interventions and strengthened its monetary policy. This signal likely ineffectiveness of the monetary policy.

Third, Anna Ingemann and Martina Facino have found that the elasticity of inter-temporal substitution (EIS) across the eurozone is heterogeneous and that this reduces monetary policy effectiveness. Differences in EIS within the eurozone are structural and relate to differences in wealth, asset market participation and credit availability, as well as cultural differences, according to the study. Also, Richard K. Crump et al. uncovered strong evidence of “excess sensitivity of planned consumption growth to expected income changes”. So, there evidence that the EIS is not constant over time and vary between countries. This make a “one size fits all” policy questionable.

Fourth, there are questions about the ECB’s theoretical understanding of the monetary transmission of negative interest rates, including the effects on banks – notably in terms of interest rate margin and pass-through to depositors -, their reactions, and how the banks and their customers adapt to the new environment. The simple competitive model of banking does not explain how a negative interest rates lead some banks to increase the cost of borrowing or shed their higher yielding assets. The more general question is about understanding possible behavioral changes, if any. Beyond the transmission to market interest rates and asset prices, transmission to the real economy may be impeded by breakdowns in the transmission channels or opposing effects with uncertain outcome. This for example the case when a reduction in interest rates leads to increased savings, possibly because of “money illusion”.

Fifth, the negative interest rate policy has negative side effects not only on bank profitability which could affect the transmission mechanism, but also possible on the destabilization of money market mutual fund industry, and threats to the survival of insurance and pension fund business models. There are also concerns about the ability of financial market infrastructures to technically deal with a reversal in the streams of interest payments.

Under the above circumstances, was it a great idea for the ECB going to negative interest rates? Experience in the eurozone and elsewhere has not vindicated the use of negative interest rates, except perhaps when the goal is to adjust the exchange rate. So, negative interest rates policy is just a continuation with a lesser effective monetary policy that is made even more constrained by frictions, exemptions and other practices. Such distortions add up to those created by the zero bound. ECB should rather seek to mitigate distortions, fix appropriate targets and make a credible commitment to achieve them.

Nonetheless, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. Appropriate policy may involve time-varying price-level target, using interest rate policy in conjunction with a specific equilibrium selection. Back in 2015, John H. Cochrane suggested that “theoretical and empirical analysis of fiscal-monetary policy coordination is the most productive way to answer the equilibrium-selection question in the future”. Whether the ECB will redouble its research efforts to investigate new policies remain to be seen.

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