Current concerns about the zero bound on interest rates

 

Much of the comments on the global financial and economic crisis have focused on the proximate causes and governance issues related to risk management, monetary policy and weak regulation. New political alignments allowed a process of global financial deregulations in the early 1970s. The political ascendancy of financial capital and extensive capital market liberalization, employment goals were abandoned in the economic policy agenda. Indeed,   price stabilization and “fiscal prudence” turned out to be the primary objectives of the economic policy. As a result, prior to the 2008 global crisis, inflation was low and close to official inflation target rates in the advanced economies. However, credit bubbles threaten the macroeconomic stability.

After the Global Crisis, academic economists and policy makers have actively participated in the debate on monetary policy in the United States and European Union. In the face of the outcomes of the crisis, central banks have dealt with a triple challenge

  • how to contain the crisis
  • how to prevent a recessionary downturn
  • how to avoid enhancing financial instability in the form of inflationary pressures or asset  and credit bubbles.

The Federal Reserve (Fed) and the European Central Bank (ECB) have faced major global financial challenges together. However, within their respective zones, they coped with their institutional set-up and governance guidelines.

After the bail-outs, their main concern is whether nominal interest rates really have a lower bound around zero per cent. After the crisis, central banks responded to the large fall in aggregate demand and the under- utilized productive resources by adjusting  the policy interest rates to, or very close to, zero. Indeed, these central banks have focused on lender-of-last-resort program extensions. The main question is: to what extent central banks can deal with huge levels of leverage, structural flaws of financial innovations (securitization, structured finance, and derivatives above all) and  lack of transparency in terms of  risk management?.

Central banks have shown that they can innovate and coordinate with other central banks on short notice when unprecedented situations of financial crisis arise. However, central banks cannot prevent financial crisis.  Considering the menace of deepening the recession, the outcome of the central banks’ management of  nominal interest rates is that  real interest rates may be (and may continue to be) negative.  Despite the evolution of nominal and real interests, big banks have restricted new lending operations because of credit and market risks. Indeed, big banks have enlarged the amount of cash in order to cope with their own losses more easily in the future.

In the 1930s, John Maynard Keynes said the liquidity trap was a period in which cash and bonds became perfect substitutes and, after the nominal interest rate has fallen to a very low level, liquidity-preference may become virtually absolute. In other words, it is difficult for central banks to reduce their policy interest rates much below zero as cash can be held as an alternative to negative interest rate bearing assets. Most people would prefer cash to holding a debt which yields. In this event the monetary authority would have lost effective control over the rate of interest.

The modern Keynesian literature emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future nominal and real interest rates. Thus, recent research indicates that monetary policy is far from being ineffective at zero bound levels, but it worked mainly through expectations.

Therefore, the question is how very low or negative interest rates translate into improved growth rates (Hannoum, 2015).  It is worth remembering that central banks consider that the monetary stimulus could stimulate short-term growth through five main channels:

  • by boosting credit to the real economy
  • by lifting asset prices
  • by forcing investors towards riskier ones
  • by lowering the exchange rate
  • by attempting to avoid deflationary pressures.

Up to now, the monetary policy of prolonged very low or negative interest rates relies on the uncertain effectiveness of these transmission channels. However, potential serious consequences for central banks could emerge. here is the threaten that  monetary policy could become subordinated to the demands of the financial markets and to the public debt burdens.

Reference

Hannoun, H (2015) “Ultra-low or negative interest rates: What they mean for financial stability and growth”, BIS Speech at Eurofi High-Level Seminar, Riga

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