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The reverse interest rate: a new motive for countercyclical macroprudential policy

By on May 2, 2021 0

The reverse interest rate: a new motive for countercyclical macroprudential policy

The prolonged period of negative interest rates in the euro area and other advanced economies has raised concerns that further monetary policy accommodation may have the opposite effect than expected. More specifically, further easing of monetary policy into negative territory risks producing contraction effects. The policy rate enters “ reverse interest rate ” territory, to use the terminology of Brunnermeier and Koby (2018), in which the usual mechanism of monetary transmission through the banking sector collapses.

A key feature for understanding the potential threat of an inversion rate is the transmission of policy rates to other interest rates (Altavilla et al. 2019, Eggertsson and Summers 2019, Erikson and Vestin 2019). It is increasingly evident that the pass-through of policy rates to bank deposit rates is increasingly imperfect for negative rates due to the reluctance of banks to cut rates below zero (e.g. Eggertsson et al. al. 2019, Heider et al. 2019). At the same time, the return on liquid assets of banks, such as reserves and government assets, decreases with a fall in policy rates. This reduces bank profitability with negative implications for the supply of credit, as also discussed in Brei et al. (2020).

This highlights an important compromise for monetary policy in a low interest rate environment, in which the central bank must balance the stabilization of inflation and the efficiency of the transmission of monetary policy through the banking sector. . In a recent article (Darracq Pariès et al. 2020a), we develop a new nonlinear macroeconomic model with a banking sector adapted to the economy of the euro zone which captures this trade-off and presents a determined reversal interest rate of endogenously.

We show that the probability of meeting the turnaround rate depends on the capitalization of the banking sector. As a result, the possibility of the reversal rate creates a new motive for macroprudential policy. Creating a timely macroprudential policy space to support the bank lending channel of monetary policy, for example in the form of a counter-cyclical capital cushion (CCyB), mitigates the risk of monetary policy hitting a rate territory. ‘reversal, or mitigate the negative implications if It does.

Monetary policy can be transmitted non-linearly when interest rates are low

We develop a new nonlinear macroeconomic model that captures the stylized facts sketched out and demonstrates the conditions under which such an inversion rate could materialize. The framework is a new Keynesian model with a banking sector calibrated to the main characteristics of the euro area economy in the current low interest rate environment.

The banking sector contains three key characteristics. First, banks are assumed to have limited capital, which gives rise to financial accelerator effects according to Gertler and Karadi (2011). Second, banks have market power in setting the deposit rate. However, if the market power of banks is strong in good times, it weakens if the policy rate approaches a negative environment, as in Brunnermeier and Koby (2018). This accounts for the increasingly imperfect pass-through of policy rates to bank deposit rates for low rates. Third, banks are required to hold low risk liquid assets for part of their funding depending on reserve requirements and regulatory constraints, such as Eggertsson et al. (2019).

These characteristics 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 lower bound of zero, a demand shock to the economy (here assumed to be a risk premium shock) may have asymmetric nonlinear effects due to the fact that monetary policy loses part of its effectiveness. Figure 1 shows that in such a situation the negative economic effects of a large contraction risk premium shock (two standard deviations) are much more severe than the effects of a small contraction risk premium shock ( one standard deviation).

Figure 1 Impulse response functions of risk premium shocks

Remarks: This figure presents the impulse response functions of risk premium shocks that differ in magnitude. One standard deviation increase (blue solid) and two (red dotted lines). The economy is initially in a state of equilibrium (risky).

Economic intuition suggests that an increase in risk premia, which is a contraction shock, affects household consumption and savings decisions as well as bank refinancing costs. Households postpone their consumption, so production decreases. This affects banks, as their return on assets is lower and asset prices fall. In addition, the financing costs of banks are increasing. Both effects reduce net worth and weaken bank balance sheets, which amplifies the shock via the financial accelerator mechanism. In response, the central bank lowers the nominal interest rate to ease the economic slowdown. However, the impact of such a policy is not linear, due to the imperfect pass-through of the deposit rate and the lower return on public assets.

The inversion interest rate as the effective lower bound of monetary policy

At very low or negative interest rates, monetary policy becomes less efficient as indicated and may even enter “reverse interest rate” territory in which a marginal adjustment in monetary policy produces contraction effects. This is illustrated in Figure 2, which shows a decline in welfare for more negative lower limits (blue line).

Figure 2 Welfare, the lower bound and macroprudential policy

Remarks: This figure presents the well-being of agents of the economy without (solid blue) and with (red dotted lines) macroprudential policy for different lower bounds of monetary policy R ^ A.

This suggests that a very negative lower bound can lead to counterproductive results, as the decline in bank profits is not offset by the decrease in the pass-through of deposit rates. At the same time, an overly restrictive lower bound, such as keeping the policy rate at positive levels, reduces welfare as the central bank forgoes potentially beneficial monetary accommodations.

The preventive creation of a macroprudential policy space can protect against the reversal of interest rates

With the capitalization of the banking sector playing a key role in the appearance of the turnaround rate, we integrate a macroprudential policy in the form of a countercyclical capital buffer rule which may 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 be released in the event of a downturn.

We demonstrate that such a macroprudential policy rule can reduce the probability of reaching the inversion interest rate. The banking industry accumulates additional capital at the right times, which can then be released during a recession. Having accumulated additional capital buffers during good times, the negative impact on banks’ balance sheets of lower monetary policy rates is mitigated. Therefore, monetary policy becomes more effective during an economic downturn, and the interest rate reversal is less likely to materialize in low interest rate states, which improves general welfare.

The positive impact of macroprudential policy is illustrated in Figure 2, where well-being with active macroprudential policy is illustrated (red line). Welfare is now considerably higher as the central bank is less likely to enter interest rate reversal territory. In fact, the optimal capital buffer rule reduces the likelihood of being at or near a “tipping point” by more than 25%. It also reduces the frequency of negative rates and economic fluctuations. This shows 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 response to the crisis could have been improved if the authorities had built more macroprudential space. This could have better protected economic activity and complemented the adjustment of monetary policy more effectively.

Conclusion

The analysis has at least two important policy implications. First, a macroprudential policy using a countercyclical capital buffer approach has the potential to mitigate and mitigate the risks of entering reversal rate territory. Second, there are important strategic complementarities between monetary policy and a counter-cyclical capital-based macroprudential policy in the sense that the latter can help facilitate the effectiveness of monetary policy, even in times of extremely low interest rates, even negative.

Author’s Note: This column represents the opinions of the authors and not necessarily those of the European Central Bank, the Bundesbank or the Eurosystem.

The references

Altavilla, C, L Burlon, M Giannetti and S Holton (2019), “The Impact of Negative Interest Rates on Banks and Businesses,” VoxEU.org, November 8.

Brei, M, C Borio and L Gambacorta (2020), “Bank intermediation when interest rates are very low for a long time”, VoxEU.org, February 7.

Brunnermeier, M and Y Koby (2018), “The reversal interest rate”, NBER Working Paper No. 25406.

Darracq Pariès, M, C Kok and M Rottner (2020a), “Reversal interest rate and macroprudential policy”, Working Paper Series 2487, European Central Bank.

Darracq Pariès, M, C Kok and M Rottner (2020b), “Strengthening the macroprudential space when interest rates are“ low for a long time ””, Macroprudential Bulletin, European Central Bank, vol. 11.

Eggertsson, G, R Juelsrud, L Summers and E Wold (2019), “Negative Nominal Interest Rates and the Bank Lending Channel”, NBER Discussion Paper.

Eggertsson, G and L Summers (2019), “Negative Interest Rate Policy and the Bank Lending Channel,” VoxEU.org, January 24.

Erikson, H and D Vestin (2019), “Transmission at slightly negative key rates: the Swedish case”, VoxEU.org, January 22.

Gertler, M and P Karadi (2011), “An unconventional monetary policy model”, Journal of Monetary Economics 58 (1).

Heider, F, S Farzad and G Schepens (2019), “Life below zero: Bank Lending under negative policy rates”, Review of financial studies 32 (10).