Weak banks could reverse effects of policy rate cuts – ECB paper

Loosening monetary policy could have a contractionary rather than expansionary effect under certain circumstances, a working paper published by the European Central Bank argues.

In Reversal interest rate and macroprudential policy, Matthieu Darracq Pariès, Christoffer Kok and Matthias Rottner say that central banks can make this less likely if they impose counter-cyclical buffers on the banking sector.  

The authors use a non-linear macroeconomic model calibrated to the eurozone economy. They find that if the economy is in a severe recession, a “reversal interest rate” – when cutting policy rates has a contractionary effect – can occur.

This finding, they say, “allows us to derive an optimal lower bound for the policy rate below which monetary policy loses its effectiveness”. In their model, the optimal lower bound for the eurozone is around -1% per annum.

A reversal interest rate event occurs when banks are in a certain condition, the authors say, for several reasons. A monopolistic banking sector’s pass-through of changes in the deposit rate will always be imperfect, and will worsen as rates approach zero or become negative. Negative shocks in the economy will damage banks’ net worth, which in turn can cause financial accelerator effects as bank lending falls.

Macroprudential policy that imposes countercyclical capital buffers on banks, the authors say, can reduce the risks of a reversal interest rate. They argue that there are “important strategic complementarities between monetary policy and a countercyclical capital-based macroprudential policy”.