Negative Interest Rates: Bad Policy for European Central Bank

Several economists for the International Monetary Fund (IMF) recently expressed concerns about moving interest rates into negative territory. They believe it could backfire on the European Central Bank (ECB), making banks less profitable overall and reducing lending.

The IMF promotes international monetary cooperation, facilitates trade, and fosters sustainable economic growth for its member countries. In a recent paper on the ECB’s monetary policy, two IMF economists, Andy Jobst and Huidan Lin, warned member banks of the monetary union were struggling to produce profits because of low-interest rates.

Further policy rate cuts could bring into focus the potential trade-off between effective monetary transmission and bank profitability. Lower bank profitability and equity prices could pressure banks with slender capital buffers to reduce lending, especially those with high levels of troubled loans.”

With a move towards low to negative rates instigated by the ECB, more money is available for investment; however, running the economy so “hot” has its downsides, not the least of which is inflation and lack of purchasing power for the euro and other countries.

Another consequence is the slim profit margins member banks are realizing. Less interest paid on loans means less profit. Banks must make up the difference by making more loans:

To some extent banks have been able to mitigate the squeeze on profitability with higher lending volumes, lower interest expenses, capital gains from investments, lower risk provisioning, small increases in fees and commissions, as well as savings from cost cutting … but there are clearly limits to such mitigation measures.

In short, instituting negative interest rates, which is tantamount to price controls, force financial institutions to a profit margin that’s untenable. Lower profitability could pressure banks to reduce lending, which is the opposite of the intention.

Rather than let the economy correct itself and establish real rates of interest, interference from central banks like the ECB risk pushing distorted financial markets beyond their ability to function.

Overall, the ECB has limited room for further substantial rate cuts without hurting the profitability of banks … the prospect of prolonged low policy rates has clouded the earnings outlook for most banks, suggesting that the benefits from a negative interest rate policy might diminish over time, while future lending growth may be insufficient to offset declining interest margins in some countries.”

Jobst and Lin point to countries like Italy and Spain where low-interest margins are resulting in weaker credit growth.

While banks may suffer from low and negative interest rates, there’s one positive consequence: negative interest rates are good news for gold.

 

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