While the U.S. Federal Reserve holds its cautious course toward higher interest rates, European central bankers have doubled down on ultra-low interest rates in the form of negative interest rates. We recently spoke with Christian Noyer, honorary governor of the Banque de France, to get his thoughts on these extraordinary monetary measures, whether negative interest rates and quantitative easing are compatible, and whether central bank actions that may work in theory will work in practice.
Q: Most people are confused by terms such as negative interest rates and quantitative easing. What are negative interest rates, and how are they different from quantitative easing?
A: Negative interest rates and quantitative easing (QE) have similar objectives, but they operate in very different ways. Both aim to reduce the cost of risk and the time value of money.
Negative interest rates mean that central banks charge a fee on overnight deposits at the central bank. When they eventually lend with a discount to commercial banks, the principal is reduced when the refinancing loan matures. In the case of the Eurosystem, this applies in particular to commercial banks’ excess reserves. QE refers to the practice by which central banks purchase longer-term assets in private markets in order to reduce their supply, raise asset prices, and lower yields all along the yield curve below prevailing market rates.
Q: I think we are already pretty familiar with QE. Negative interest rates are harder to wrap one’s head around. Can you say more about how negative interest rates actually work?
A: Negative interest rates can be administered as actual fees — the European Central Bank (ECB) charges European banks 0.4 percent on excess reserves, for example. They can be imposed on securities by issuing the principal with a premium. Their aim is not only to lower short-term interest rates further but also to suppress short maturity bond yields and push banks to lend.
Q: These policy innovations don’t seem to have had much effect. How are negative interest rates working with QE?
A: In a sense, they are working against each other. QE creates excess liquidity that goes to the central bank in the form of excess reserves. When the central bank charges for excess reserves, commercial banks have to pay the costs. If they increase lending, that very action further increases deposits as borrowers deposit their loan proceeds before they draw them down. If banks do what the central bank wants them to, they end up with more reserves and more costs.
Q: What options do banks have?
A: They can pass these costs on to depositors by charging them fees to hold their money. In principle, households would then be encouraged to spend and corporations to invest.
In practice, things don’t work like that. There is competition between banks. Banks can’t risk losing a massive amount of deposits. They need deposits for long-term funding. There are also regulatory reasons. Banks need to keep deposits in order to satisfy the liquidity regulatory requirements.
Banks can pass the cost on to the borrowers by increasing credit spreads. In this way, they tighten credit conditions, which is exactly the opposite of what the monetary authorities want.
Or they can absorb the costs themselves by reducing their profitability and therefore their capital base, which is the opposite of what regulators want.
Q: Does this imply that banking regulation makes this problem worse? Regulators are raising capital and liquidity standards, which raises the costs of lending at the same time that central banks and negative interest rates are likely pushing those costs up even more.
A: I can’t argue with your logic. These tensions are much greater in Europe than in the United States because banks are the principal credit intermediaries in Europe, whereas market funding is much more important in the United States.
Q: When you take account of these contradictions you really have to wonder — do the European central banks understand these conflicts and, if so, why are they proceeding as they are? The U.S. Fed has sworn off negative interest rates.
A: You have asked two questions in one (laughter). I am not sure that these contradictions are all that well understood, frankly. The effects of negative interest rates and QE are largely assumed to keep stock market and bond prices higher than would otherwise be the case. But the effects of these policies on banks, borrowers and credit creation? I don’t think they are well understood at all.
Still, you have to consider the position in which Europe finds itself. The United States is much further ahead in recovering and expanding than Europe. Just two years after the global financial crisis, Europe had the sovereign debt crisis in 2011, with several subsequent reverberations since. We are still recovering.
Europe is still struggling with the effects of these debt crises, and disinflationary forces remain strong. The ECB is using all possible tools at the same time to boost the European economy, even if some of them might be questionable. We are getting late in this global cycle, and we need to get the economy moving.
Q: Let me ask one final question since you mentioned that we are late in the economic cycle. What if we encounter another recession? Will central banks have the tools to respond?
A: Let me start by saying that it would be a mistake to sustain these unconventional tools too long. We have to show the same determination in normalizing these policies — and even tightening policy when the time comes — that we have in supporting the economy by adding liquidity and supporting financial markets and credit creation. If we pursue the current unconventional course too long, we will not have the capacity to accommodate and support the economy when the next downturn comes.
It is the normalization of the economy and economic growth that will normalize monetary policy. The Fed has taken the lead because the U.S. economy is well ahead in the recovery. Once European growth begins to improve, I am sure the ECB will follow.
In the end, you have to remember that the relationship between monetary policy, financial institutions and markets, and the economy is a delicate one. It requires good judgment and good communication skills. European central banks are working very hard to create the economic and employment gains necessary to provide a strong foundation for when conditions demand they reverse policy and raise interest rates — a time that will inevitably come down the line.
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