Central banks also have limits
In recent years, the central banks have increasingly expanded the monetary policy stimulus and lowered interest rates to zero percent and in some cases even into negative territory. According to the advocates of a negative key interest rate policy (NIRP), the possibility of lowering the key interest rate below the zero percent threshold strengthens the monetary policy transmission process. Compared to a "regular" interest rate cut, the push into the negative range would allow the monetary policy impulse to unfold its effect via additional transmission channels.
However, negative key rates are not a panacea and are not free of undesirable side effects. A study by Brunnermeier and Koby ("The Reversal Interest Rate") has looked into this issue and in particular examined the effects of NIRP on bank lending. It was found that above a certain negative key interest rate level, financial institutions no longer expand their lending, but rather restrict it, since the earnings no longer cover the risk costs. Thus, the hoped-for stimulating effect of an interest rate cut disappears into the negative. The interest rate at which this effect occurs is known as the "Reversal Interest Rate". In addition to this effect, negative interest rates increase the incentive to hold cash, since the cost of holding money at banks with negative interest rates increases. Both effects together limit the central banks' scope for action when interest rates are lowered.
There is a technical solution for both problems. With the introduction of the tiering system (whereby a portion of the money parked by banks with the ECB is excluded from negative interest rates) and the particularly favorable TLTRO III conditions, the ECB is attempting to somewhat mitigate the effects of the negative interest rate policy on the banking sector. A possible (partial) introduction of a crypto-currency could help to control the problem of cash holdings. With these instruments, the key interest rate could be lowered further into negative territory than before. The problem here is that there could be a creeping loss of confidence. Negative interest rates are ultimately something unnatural and in the medium term contradict a future-oriented basic understanding of society.
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