What are the risks of a prolonged period of low interest rates?

After the Global Financial Crisis of 2007 to 2009, the central banks of many advanced economies dramatically eased monetary conditions. The strong monetary policy easing at the beginning of the crisis allowed economies to better cope with its consequences. Mainly in Europe, monetary policy remained highly accommodative long after the crisis had subsided and many economies had returned to economic expansion. As a result of this monetary policy easing – unprecedented in scope and length – both short-term and long-term risk-free interest rates have declined to zero or below it, and risk premiums on various assets have been compressed, increasing the vulnerability of financial systems.

Over the last decade, the body of empirical literature exploring the adverse effects of the low interest rate environment has grown significantly. These studies document how the post-crisis period of very low interest rates has contributed to the build-up of financial vulnerabilities and imbalances, resulting in higher systemic risk. This fact has motivated us to provide a comprehensive overview of the literature, categorise it, and formulate a few policy considerations and recommendations, which we present in our research paper A Prolonged Period of Low Interest Rates: Unintended Consequences. We identify five broad categories and 22 subcategories of financial vulnerabilities which may be created and fuelled by a prolonged period of low interest rates (Table 1). These financial vulnerabilities exacerbate the impact of adverse shocks on the economy and can thus deepen economic recessions or crises.

In our paper, we also address the role of the natural interest rate, which is considered to be the neutral level of the monetary policy rate. In other words, if the real interest rate (the inflation-adjusted monetary policy rate) is below the natural rate, monetary policy is considered accommodative; if the real interest rate is above the natural rate, monetary policy is considered restrictive. Why is this important? Because real interest rates all over the world have been on a downward trend for a very long time and have remained exceptionally low in the last two decades. Does this mean that monetary policy has been too accommodative for an extended period of time? Or have natural (neutral) rates declined along with monetary policy rates, and monetary policy is therefore more or less neutral? This is very hard to answer, and views differ widely depending on the model used to estimate this unobservable variable. Given the significant financialisation of advanced economies and the strong correlation between the business and financial cycles (Jordà et al., 2013; Jordà et al., 2017), financial factors should play a prominent role in macroeconomic models, including those used to estimate natural interest rates. Therefore, in our paper we compare the natural interest rate estimated using two models – with and without financial factors – for six large European economies inside and outside the euro area.

Our estimation results point to differences between the two approaches, stressing the role of financial factors in macroeconomic models and monetary policy decision making. The difference between the estimates of the natural interest rate with and without financial factors varies not only across economies, but also over time, pointing to different and changing needs of these economies in terms of monetary policy. Excluding macro-financial links from the estimation of the natural interest rate may therefore lead to an inappropriate assessment of the monetary policy settings, which may have significant consequences for both the real economy and the financial system in the longer term.

In our paper, we also address the situation in which the normalisation of monetary policy can be costly (the “point of no return”). Keeping interest rates low for a prolonged period can lead to over-indebtedness of the economy, overvalued asset prices and undervalued risks, misallocation of resources and credit, and lower overall productivity. In such a situation, the central bank may be constrained in its decision-making, as tightening monetary conditions, however desirable, may lead to an increase in the debt service of households and non-financial corporations, thereby increasing non-performing loans and risk premiums. Very low interest rates may lead to an increasing number of “zombie firms” (firms with limited profitability). These zombie firms are found to be linked to weak and undercapitalised banks willing to repeatedly extend lending to these firms to avoid the recognition of non-performing loans and meet capital requirements (Andrews and Petroulakis, 2019; Caballero et al., 2008; Schivardi et al., 2017; Storz et al., 2017). The gradual “zombification” of the economy may lead to overcapacity and downward pressure on markups and prices (Acharya et al., 2020a).

Given the growing body of studies showing that a prolonged period of low interest rates may support the build-up of financial imbalances and exacerbate existing financial vulnerabilities, we argue that changes to the current approach to monetary policy should be discussed more intensively. First, monetary policy should act symmetrically over the medium to long term. Second, both the short-term and long-term costs and benefits of pursuing accommodative or restrictive monetary policy should be accounted for. Third, major world central banks should take into account the impact of their policies on countries both inside and outside their monetary unions. Some of the world’s major central banks have already begun to take steps. In particular, the European Central Bank and the US Fed have opened up to opinions and discussions with the public as part of the review of their strategies.

In the policy decision-making process, short-term benefits should not be favoured at the expense of long-term losses, and central banks should not give up on overall financial and macroeconomic stability in the pursuit of price stability. From a conceptual point of view, this can be seen as a reasonable requirement. From a practical point of view, however, it may be difficult for the central bank to reliably assess both the short-term and long-term effects of its policies on price and financial stability. This is due to different probabilities of failure to fulfil the two objectives and different time horizons. The monetary policy horizon for achieving the inflation target is usually significantly shorter than the horizon of potential materialisation of systemic risks that are accumulating in the economy at the time. One of the first steps the central bank can take in this regard is to strengthen its analytical framework by including financial variables and links between the real economy and the financial system, taking into account potential non-linear effects and feedback loops, and prolonging the analytical horizon beyond the standard monetary policy horizon.

In order to find a suitable combination of monetary and macroprudential policies, it is necessary to take into account the effects of both and their interactions. Some may argue that macroprudential regulation and microprudential supervision should be responsible primarily for financial stability, while monetary policy should focus on price stability. However, this approach may prove counterproductive in the long term given the strong correlation between the business and financial cycles. Macroprudential policy measures can, to some extent, help mitigate existing financial vulnerabilities and imbalances and increase the resilience of the financial system. However, potential adverse side effects may arise if the measures are not coordinated with monetary policy. For instance, it may be very difficult for some banks to adequately meet the capital requirements in a prolonged period of low interest rates and low profitability. Regarding borrower-based measures such as limits on the LTV, DTI and DSTI ratios, studies have shown that they may have unintended distributional and reallocation effects, i.e. they may lead to increased risk taking by banks in order to maintain profitability in the low interest rate environment (Acharya et al., 2020b; Peydró et al., 2020). The combination of more demanding macroprudential policy and a prolonged period of low interest rates may also incentivise a shift of activities towards the non-banking and shadow banking sectors, which are generally less regulated (Hodula, 2018; Hodula, 2019). Another aspect that cannot be overlooked is the delay between the announcement and the entry into effect of macroprudential measures. While monetary policy tools take effect immediately or with very little delay, macroprudential policy tools often come into effect with relatively long delays. It is therefore appropriate to apply macroprudential policy instruments preventively and well in advance.

Literature

Acharya, V., Crosignani, M., Eisert, T., Eufinger, C. (2020a): Zombie credit and (dis)inflation: Evidence from Europe. NBER Working Papers 27158, National Bureau of Economic Research.

Acharya, V., Bergant, K., Crosignani, M., Eisert, T., McCann F. (2020b): The anatomy of the transmission of macroprudential policies. IMF Working Papers 20/58, International Monetary Fund.

Andrews, D., Petroulakis, F. (2019): Breaking the shackles: Zombie firms, weak banks and depressed restructuring in Europe. Working Paper Series 2240, European Central Bank.

Caballero, R. J., Hoshi, T., Kashyap, A. K. (2008): Zombie lending and depressed restructuring in Japan. American Economic Review, 98(5):1943–77.

Hodula, M. (2018): Off the radar: Exploring the rise of shadow banking in the EU. Working Papers 16/2019, Czech National Bank.

Hodula, M. (2019): Monetary policy and shadow banking: Trapped between a rock and a hard place. Working Papers 5/2019, Czech National Bank.

Jordà, O., Schularick, M., Taylor, A. M. (2013): When credit bites back. Journal of Money, Credit and Banking, 45(2):3–28.

Jordà, O., Schularick, M., Taylor, A. M. (2017): Macrofinancial history and the new business cycle facts. In Eichenbaum and Parker, editors, NBER Macroeconomics Annual 2016, volume 31, National Bureau of Economic Research.

Peydró, J.-L., Rodriguez-Tous, F., Tripathy, J., Uluc, A. (2020): Macroprudential policy, mortgage cycles and distributional effects: Evidence from the UK. Staff Working Paper 866, Bank of England.

Schivardi, F., Sette, E., Tabellini, G. (2017): Credit misallocation during the European financial crisis. Bank of Italy Temi di Discussione 1139, Bank of Italy.

Storz, M., Koetter, M., Setzer, R., Westphal, A. (2017): Do we want these two to tango? On zombie firms and stressed banks in Europe. Working Paper Series 2104, European Central Bank.