SNB - Monetary policy using negative interest rates: a status report

In January 2015, the Swiss National Bank discontinued the minimum interest rate against the euro, and at the same time lowered the interest rate on banks’ sight deposits held at the SNB to –0.75%. Today – almost two years later – not only short-term interest rates, but yields on 10-year and even longer-dated Confederation bonds, are negative. Some corporate bonds in Swiss francs are now also negative yielding.

Many people consider negative interest rates to be unnatural. Paying interest on credit balances seems to violate the logic and laws of economics. Savers worry about their capital, banks about their profitability and pension funds about meeting their obligations. There are also doubts about whether the SNB’s negative interest rate policy is having the desired effect. Negative interest rates are certainly unusual. They are uncharted territory and represent a major challenge for many players in the economy, particularly investors.

The SNB takes these concerns very seriously. In my speech today, I would like to explain our negative interest rate policy. I will start by clarifying that there are two reasons for the low or even negative interest rates in many countries. First, the global equilibrium interest rate has fallen over recent decades. Second, since the financial crisis, monetary policy worldwide has been expansionary as a result of low inflation and weak economic recovery.

For Switzerland, a country with generally low interest rates, these two factors – a long-term decline in the equilibrium interest rate and expansionary monetary policies around the world – have made the negative interest rate necessary in order to ensure appropriate monetary conditions. As a small open economy, we cannot decouple ourselves from a global environment of low interest rates.

In the second part of my speech I will look at whether the negative interest rate policy is fundamentally effective. As this status report will show, the laws of economics do not change significantly when interest rates turn negative. As far as the mechanism of monetary policy is concerned, there is therefore no reason why the policy rate should not be reduced below the zero lower bound in the case of a country like Switzerland. On the contrary: without negative interest rates, the Swiss franc would have appreciated even more strongly, growth would have collapsed, accompanied by even lower inflation, and unemployment would have risen.

Nevertheless, phases of low or negative interest rates also present monetary policy challenges and have economic side-effects, which must not be ignored and which I would like to address in the third part of my speech. I will stress that expansionary monetary policy is no panacea for growth in advanced economies. Only structural reforms and adjustments in the real economy can create the conditions for a sustained recovery – and thus for a normalisation of monetary policy. Expansionary monetary policy can make these necessary adjustments easier, but it cannot replace them and must not delay them.

Before talking about the mechanism of negative interest rates in Switzerland, I would first like to examine the international environment and explain why global interest rates today are so low.

Low rates as a global phenomenon

The current very low interest rate level is the result of a global secular trend. Interest rates have not just been declining since the outbreak of the financial crisis, they have been falling steadily in recent decades. Chart 1 shows that nominal yields on government bonds with a remaining maturity of ten years in Switzerland, Germany and the US are more than 6 percentage points lower today than they were back in 1990.

Nominal interest rates are currently at a record low worldwide. But it is important to distinguish between nominal interest rates and real interest rates, which are ultimately relevant for most economic decisions. I should perhaps mention here for the sake of completeness that, put simply, real interest rates are nominal interest rates less inflation. Chart 2 shows longterm real interest rates in Switzerland, Germany and the US, calculated as the difference between the nominal yield on 10-year government bonds and the observed inflation rate. I should emphasise two points: First, while real interest rates in Switzerland are currently negative, a historical comparison shows that this is by no means a new phenomenon. For example, real interest rates in Switzerland were also negative in the 1990s. Second, real interest rates have fallen on a global basis over the last 20 years.

I shall now turn to an economic concept that plays a key role in the current monetary policy debate, namely the equilibrium real interest rate. The equilibrium real interest rate is not directly observable and is determined by fundamentals such as time preferences and the age structure of a society, which define the supply of savings and the demand for investment. The SNB controls a short-term nominal interest rate. By contrast, it has only an indirect and temporary influence on long-term real interest rates, which drive investment decisions. Longterm real interest rates are primarily determined by saving and investment decisions and hence by market forces.

If the central bank wishes to stimulate the economy and increase inflation, it cuts the policy rate. Since inflation does not react immediately, real interest rates temporarily fall below the equilibrium rate. This leads – again temporarily – to higher growth and more inflation. If, on the other hand, the central bank wishes to curb inflation, it increases its policy rate. I deliberately used the word ‘temporarilyֹ’ because if monetary policy were to target real interest rates below the equilibrium rate on a sustained basis, inflation would go on rising but this policy would not result in higher real growth in the long term. On the contrary, uncertainty about the path of inflation would reduce growth potential. This is one of the reasons why central banks are tasked with ensuring price stability. For this mandate to be fulfilled, the policy rate must be set such that, at the desired inflation rate, the real interest rate corresponds with the equilibrium rate in the medium term.

It is likely that the real equilibrium interest rate is lower today than in the past. The case for this hypothesis is supported by the fact that real interest rates have been falling globally for a considerable time because, it is argued, people are investing less and simultaneously displaying a greater propensity to save. The propensity to save is increasing due to population ageing. This demographic trend can be measured using the old age dependency ratio, which measures the ratio of people over 64 to the working age population. An ‘older’ population has a higher old age dependency ratio. Chart 3 shows that the old age dependency ratio in Switzerland, as in many other countries, is rising. Pensioners live off their savings. And an ageing population needs to save more today in order to be able to finance a specific level of consumption in the future. Another cause of the increased supply of savings is the integration of China into global financial markets. Savings in China are high as a result of its ageing society and its rudimentary state pension system. In the current economic situation, uncertainty regarding the future development of the economy in certain parts of the world may also have pushed up the supply of savings.

While the propensity to save has increased, the willingness to invest may also have fallen. On the one hand, this may once again reflect heightened uncertainty over future economic conditions. On the other, expectations of lower productivity growth might also be playing a role. Furthermore, industrial economies are being transformed into service economies, with potentially lower capital needs.

All these factors have resulted in a relatively low real equilibrium interest rate today – across the world, and thus also in Switzerland. Moreover, global monetary policy is expansionary due to undesirably low inflation and subdued economic growth in the wake of the financial crisis. The long-term downward trend in interest rates globally and expansionary monetary policy occasioned by cyclical factors have therefore combined to produce historically low interest rates.

Transmission channels of negative interest rates in Switzerland

Irrespective of the equilibrium rate, questions arise regarding the transmission mechanism of monetary policy below the zero lower bound. Specifically, how does monetary policy using negative interest rates effect a rise in inflation?

As you will probably remember from your student days, monetary policy usually operates through a variety of transmission channels. For a small open economy like Switzerland, the exchange rate channel is the most important. Lower interest rates, other things being equal, make the Swiss franc less attractive as an investment currency. The franc loses value, which makes Swiss goods cheaper abroad, and leads to a rise in net exports. This in turn raises GDP and inflation in Switzerland. Depreciation of the Swiss franc also has a direct impact on inflation because import prices rise.

A reduction in interest rates also operates via the credit channel. Put simply, if the SNB reduces the short-term interest rate, longer-term market rates also fall. Loans become cheaper and this stimulates consumption and investment. These factors boost the economy and inflation rises.

Is the negative interest rate in Switzerland having the anticipated effect? Let me first look at transmission via the exchange rate channel. Historically, Switzerland has always had lower interest rates than most other countries, particularly euro area countries. The interest rate differential reflects not only lower average inflation in Switzerland compared to other countries, but also the country’s political stability and credible monetary policy. Investors are prepared to hold Swiss franc investments at lower yields. Chart 4 plots policy rates in Switzerland and in the euro area. Since the outbreak of the financial crisis, the interest rate differential has become ever narrower. When the negative interest rate was introduced in the euro area in June 2014, the interest rate differential even turned negative.

Every subsequent monetary easing measure by the ECB added to the pressure on the Swiss franc, which at the time was subject to the minimum interest rate against the euro. Chart 5 shows the exchange rate of the euro against the Swiss franc (blue curve) and against the US dollar (red curve). In the second half of 2014, the value of the euro fell sharply against all major currencies. This meant that the minimum exchange rate was no longer sustainable. The volume of interventions that would have been required to defend the minimum exchange rate, even just temporarily, threatened to spiral out of control. This is why we adjusted our monetary policy in January 2015. The discontinuation of the minimum exchange rate caused the Swiss franc to appreciate, by an amount roughly equal to the gain in value that most other currencies had experienced against the euro in the preceding months.

Our monetary policy since then has been based on two elements: the negative interest rate of –0.75% on banks’ sight deposits held at the SNB and our willingness to intervene in the foreign exchange market, as necessary. The negative interest rate in Switzerland has at least partially restored the original interest rate differential and thus reduced pressure on the Swiss franc. As Chart 6 shows, the real external value of the Swiss franc has been on a gradual downward trajectory since mid-2015. Even in times of increased market volatility, as in the aftermath of the British EU referendum in June this year, the Swiss franc has remained broadly stable against the euro and the US dollar. Without negative interest and our willingness to intervene, the Swiss franc would have appreciated, growth would have slowed, and inflation would have fallen further.

The impact of negative interest rates on the exchange rate is crucial for us because Switzerland is a small open economy and foreign trade is a very important factor in our economic performance. In 2015, exports contributed over 50% to GDP, while imports accounted for about 40%. Movements in the Swiss franc therefore have a big impact on domestic economic developments. The Swiss franc is still significantly overvalued and this represents a major challenge for many sectors. Imported goods and services also have a high weighting in the Swiss consumer price index basket. The appreciation of the Swiss franc since the financial crisis was therefore also directly reflected in the inflation rate. This has generally been negative over the last five years, as you can see in chart 7. The biggest contribution to low inflation, the red bars in the chart, comes from imported goods. Also, the fall in oil prices, the yellow bars, has contributed to low inflation. Thanks to the stabilisation of both the Page 6/16 exchange rate and oil prices, inflation has been climbing since the end of 2015, and we forecast that it should re-enter positive territory in the coming quarters.

Now let me turn to the credit channel. In a functioning transmission mechanism, you would expect to see a lower general interest rate level and rising credit volumes following an interest rate cut by the central bank. Did interest rates in Switzerland fall after the introduction of negative interest? And how have credit volumes and bond issuance changed?

Since the reduction in interest on banks’ sight deposits held at the SNB to –0.75% in January 2015, yields on long-term Confederation bonds have fallen by more than half a percentage point, as chart 8 shows.2 Interest rates on corporate bonds, the red curve in the chart, have also declined sharply. The financing costs of bond-issuing companies have thus fallen. The situation regarding interest rates for bank loans is rather different. As you can see in chart 9, initially they did not fall; indeed, they rose slightly. This seems surprising at first glance but is attributable to the fact that banks tried to offset a further decline in their interest margin with increased income from credit business.

Meanwhile, interest rates on mortgage loans are also lower than before the introduction of negative interest. Thus, we can conclude that taking a policy rate into negative territory has a similar effect, in terms of transmission to other interest rates, to cutting a policy rate in positive territory.

Although interest rates have fallen, no significant increase in credit growth has been observed over the last two years. The volume of bank loans to businesses and households has risen further, as you can see in chart 10, but credit growth has weakened. This slowdown in growth is particularly evident among loans to private, non-financial corporations. However, the picture is different for companies that are able to finance themselves via the capital market, as chart 11 shows. Domestic non-financial corporations have exploited the low capital market interest rates and issued more bonds since the introduction of the negative interest rate.

As a preliminary conclusion, we may state that the negative interest rate in Switzerland principally operates via the exchange rate channel. Together with our willingness to intervene in the foreign exchange markets, it has helped to ensure that the Swiss franc has not strengthened further despite heightened uncertainty, for example in the wake of the British EU referendum. Moreover, yields on government and corporate bonds have declined since the negative interest rate was introduced, as did mortgage rates, albeit to a lesser extent. Overall, financing costs for households and businesses are lower today than they were before the introduction of negative interest. Along with the rise in the volume of bonds issued, this is evidence that negative interest is also having some impact via the credit channel, even though growth in bank lending has not risen as would normally be expected.

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