Instead, deleveraging seems to be the key factor determining the speed of recovery Figure 4, right-hand panel. Overall, these results support the relevance of balance sheet-related headwinds in reducing monetary policy effectiveness once the acute crisis phase is over. Other studies test directly for the effect of specific types of headwind, in particular, debt overhang and heightened uncertainty. Bloom et al show for the United Kingdom that higher uncertainty, measured by stock market volatility proxying financial headwinds more generally , [24] significantly reduces the responsiveness of investment to demand conditions, which in turn depend on the monetary policy stance.
Similarly, Aastveit et al find that in the United States the monetary transmission to real output is weaker when uncertainty also measured by stock market volatility is high. They interpret this result as reflecting the effect of uncertainty on investment but acknowledge that other mechanisms might also be at work since the response of consumption drops significantly too.
This suggests that the relationship between uncertainty and monetary transmission may itself be state dependent: while monetary policy may be more effective in the acute crisis phase where it can work to lower the elevated level of uncertainty and tail-risk perceptions, heightened uncertainty in general seems to sap monetary policy effectiveness. The literature on the effectiveness of unconventional monetary policies implemented in the wake of the GFC should also give us some clues about monetary policy effectiveness in environments of persistent headwinds and low interest rates.
Indeed, the lacklustre recovery from the GFC has raised doubts about the effectiveness of extraordinary measures, as discussed in BIS There is by now a large literature assessing the effectiveness of the measures on financial market prices and a somewhat smaller one investigating the ultimate effect on the macroeconomy see Borio and Zabai for an overview.
The overall picture is that the measures have been effective in easing monetary conditions by lowering interbank rates, bond yields and credit risk spreads, and, less conclusively, that these effects have also boosted the macroeconomy.
For our purposes, however, the extant studies are less informative than would be desirable. The reason is that they do not specifically test the hypothesis of reduced effectiveness at low rates. More generally, they tend to assume that previous relationships continue to hold — whether these concern the link between central bank balance sheets and activity and hence indirectly interest rates , or that between interest rates and economic activity.
One obvious reason is the limited sample size. Indeed, for any time series analysis of the extraordinary measures' effect on macroeconomic variables the sample period is typically rather short. That said, with now eight years of available data, it is becoming easier to assess whether the effects have changed over time, although the results should be taken with a pinch of salt. Similar evidence is reported in Haldane et al They find that QE shocks have a significant effect when financial market stress is high but not when it is low, with the two regimes roughly coinciding with the sample split of Hesse et al Panizza and Wyplosz explore the decreasing effectiveness hypothesis for the core advanced economies that implemented large-scale asset purchases United States, euro area, Japan and United Kingdom , also based on sub-sample analysis, and come to inconclusive results.
For some empirical exercises they find decreasing effectiveness, but not for others. This evidence of potentially reduced effectiveness of unconventional monetary policy may reflect various factors. One possibility is headwinds or inherent nonlinearities at low rates.
Another may relate to factors specific to large-scale asset purchases. For instance, such purchases may be most effective when financial markets are segmented and dislocated, so that the authorities' intervention can help alleviate the corresponding distortions. As the distortions vanish over time, the effectiveness of policy may diminish. Moreover, there are limits to how far risk premia can be compressed, expectations guided and interest rates pushed into negative territory.
Indeed, the consecutive programs seem to have had a progressively smaller effect on financial market prices Figure 6. The reduction in bond yields and loan rates per dollar spent in the programs have consistently fallen over time in the G3 economies. This might simply reflect the fact that the programs were increasingly well anticipated by market participants. But the alternative possibility cannot be excluded either. In sum, there is evidence that monetary transmission is weaker in recoveries from balance sheet recessions.
The conditions identified with weaker transmission are also those that would be expected to be associated with lower interest rates. This is the case for high debt overhangs, the recovery phase after banking crises and, admittedly less specifically, high uncertainty. Thus, the detected asymmetries may at least in part also reflect headwinds that tend to blow when rates are generally low. There is very limited analysis of nonlinearities in monetary transmission linked to the level of interest rates.
The empirical literature is scant for both nonlinearities in aggregate relationships and in specific channels. The positive link between interest rates and bank profitability has been long established in the academic literature Samuelson ; Flannery ; Hancock English studies the link between interest rate risk and bank interest rate margins in ten industrialised countries.
He finds that, as the average yield on bank assets is more closely related to long-term rates than the average yield on liabilities, a steep yield curve raises interest margins. More recently, Alessandri and Nelson establish a positive long-run link between the level and slope of the yield curve, and bank profitability in the United Kingdom.
Genay and Podjasek also find that persistently low interest rates depress US banks' net interest margins. They also note, however, that the direct effects of low rates are small relative to the economic benefits, including through better support for asset quality.
For Germany, Busch and Memmel argue that, in normal interest rate environments, the long-run effect of a basis point change in the interest rate on net interest margins is very small, close to 7 basis points. In the recent low interest rate environment, by contrast, they find that interest margins for retail deposits, especially for term deposits, have declined by up to 97 basis points.
The Bundesbank's Financial Stability Review of September , analysing 1, banks, also finds that persistently low interest rates are one of the main risk factors weighting on German banks' profitability.
Borio et al revisit the link between bank profitability and interest rates for a sample of internationally active banks.
In contrast to previous studies, they allow for nonlinearities in the relationship, as theory would suggest. They find evidence that, controlling for aggregate demand, a reduction in both short-term interest rates and yield curve slope depresses the return on assets, and that the effect increases when rates are lower or the yield curve is flatter Figure 7.
The estimated effect is significantly larger than in studies that do not allow for nonlinearities. The effect turned negative in the following four years —14 , lowering ROA by an estimated cumulative 0.
In another recent paper, Claessens, Coleman and Donnelly confirm the findings of Borio et al based on a sample of 3, banks from 47 countries for the period — They classify countries for each year as being in a low- or high-rate environment based on whether the three-month Treasury bill rate was below or above 1. After documenting that both net interest margins and returns on assets are on average higher in high-rate environments, they find that the negative effect of a decrease in the short-term interest rate is statistically larger in low-rate regimes.
These findings suggest that, over time, bank capital is negatively affected by lower interest rates and that the effect is larger when rates are low. This could then inhibit credit expansion if the supply of credit is capital constrained, especially given that banks are generally reluctant to raise capital externally. The results reported in Gambacorta and Shin suggest that higher bank capital is indeed associated with stronger lending, and that the mechanism involved in this channel is the lower funding costs enjoyed by better capitalised banks.
Borio and Gambacorta directly address the question of the effect of low interest rates on bank lending. They find evidence that lending becomes less responsive to reductions in short-term interest rates when interest rates are already low.
Figure 8 conveys this point in a simple way based on raw data. The figure plots the average log level of lending to the non-financial sector of internationally active banks against the average short-term interest rate that each bank has faced in the jurisdiction in which it operates.
The usual negative link between lower rates and bank loans is not apparent at very low rates middle panel — in fact, the relationship switches sign. Borio and Gambacorta find that the pattern suggested by Figure 8 also holds after controlling for business and financial cycle conditions, and different bank-specific characteristics, such as liquidity, capitalisation, funding costs, risk and income diversification. Importantly, it also holds when financial crises are controlled for. And it operates through the effect of lower rates on net interest margins.
A simple back-of-the-envelope calculation suggests that the reduction of net interest income caused by the low-rate environment could explain one-third of the subdued evolution of lending in the period — And fully controlling for the various influences, including weakness in loan demand, is not straightforward.
But the results do suggest that the effect could be material and worthy of further exploration. Overall, therefore, there is evidence that persistent low interest rates compress net interest margins and bank profitability, and that such a negative effect on bank profitability may in turn inhibit lending.
How relevant this effect is for aggregate macroeconomic outcomes remains an open question. A screening of the literature reveals that work on the possible nonlinear effects of low interest rates on consumption and saving is very limited. Recently, Cliffe reported the results from an Ipsos survey that sought to shed some light on this question.
The survey asked 13, consumers from Europe, the United States and Australia how their saving behaviour had changed in response to low interest rates and how they would react to negative interest rates in the future.
According to this survey, 31 per cent of respondents had changed their behaviour, albeit possibly only their portfolio decisions. Of those that did change their behaviour, some 38 per cent said that they had saved less. However, as many as 17 per cent said that they had in fact saved more.
The rest answered that they had mainly changed their asset allocation. This indicates the possibility of adverse effects from very low rates. But the study is silent about how behaviour would have changed at higher rates. Recent BIS research explores further the possible nonlinearities in the consumption-interest rate nexus through formal panel-econometric analysis. Specifically, Hofmann and Kohlscheen estimate reduced-form regressions linking real consumption growth to the level of the interest rate.
Nonlinearities are modelled using piece-wise regressions, allowing the interest rate semi-elasticity to vary across different interest rate level thresholds. The results yield two main insights. First, real consumption growth seems to be linked to the level of nominal rates rather than real rates, pointing to the empirical relevance of money illusion or specific transmission channels working through, or proxied by, the nominal interest rate.
The magnitude of the elasticity rises from 0. The nonlinearity also carries over to aggregate output growth, albeit in this case it is weaker and is not statistically significant owing to large confidence bands, suggesting that the nonlinearity works mainly through consumption.
These findings could be interpreted as indicating a flattening of the IS curve at low rates. However, the nonlinearities detected at such an aggregate level cannot shed light on the underlying mechanisms. They might reflect specific nonlinear effects of low interest rates on consumption arising from the channels discussed before. Yet, just as the studies testing for the role of headwinds may pick up effects originating from low rates, the detected lower interest rate elasticity at low interest rates may likewise partly reflect the effects of headwinds, as the two mechanisms cannot be clearly disentangled in an empirical analysis of aggregate relationships.
The empirical literature on the existence of possible resource misallocation at very low interest rates typically finds evidence of such a mechanism at work.
The market congestion created by the zombies reduced the profits of healthy firms, depressing investment, employment growth and productivity. A recent study by the OECD suggests that such zombification is a more general phenomenon since the mid s. Specifically, Adalet McGowan, Andrews and Millot show that zombie firms, defined as old firms that have persistent problems meeting their interest payments, are stifling labour productivity performance because they are themselves less productive and because they constrain the growth of more productive firms.
This paper suggests that the rise of the zombie firms has probably been a key factor behind weak investment and low productivity growth in the OECD countries over this period, and that forbearance lending has probably been a channel through which zombie firms contribute to the productivity slowdown.
There is, however, only scant specific econometric evidence on the role that very low interest rates play in this context. The bank-level regressions reported by Lepetit et al indicate that banks' loan charge-offs significantly increase with the level of short-term interest rates, consistent with the prediction of their theoretical analysis.
Similarly, Borio et al find that the interest rate sensitivity of loan-loss provisions increases at low rates, which might reflect evergreening i.
But in both cases the link between interest rates and loan charge-offs could also reflect other mechanisms, notably the effect of monetary conditions on default probabilities through aggregate demand. Closely related evidence on possible misallocations comes from a recent paper by Acharya et al , who study the effects of the ECB's Outright Monetary Transactions announcement.
The paper finds that banks that benefited from the announcement through the revaluation of their sovereign bond holdings increased their overall loan supply but that this supply was mostly targeted towards low-quality firms that enjoyed pre-existing lending relationships.
There was, however, no positive effect on real economic activity, such as on employment or investment, as these firms mainly used the newly acquired funds to build up cash reserves. The paper further documents that creditworthy businesses in industries with a prevalence of zombie firms suffered significantly from the misallocation of credit and that this slowed down the economic recovery. This review suggests that both conceptually and empirically there is support for the notion that monetary transmission is less effective when interest rates are persistently low.
Reduced effectiveness can arise for two main reasons: i headwinds that typically blow in the wake of balance sheet recessions when interest rates are low e. Our review of the existing empirical literature suggests that the headwinds experienced during the recovery from balance sheet recessions can significantly reduce monetary policy effectiveness.
There is also evidence that lower rates have a diminishing effect on consumption and the supply of credit. Importantly, these results point to an independent role for nominal rates, regardless of the level of real inflation-adjusted rates. Our review reveals that the relevant theoretical and empirical literature is much scanter than one would have hoped for, in particular given that periods of persistently low interest rates have become more frequent and longer lasting.
While there are appealing conceptual arguments suggesting that monetary transmission may be impaired when rates are low, many of these have not been formalised by means of rigorous theoretical modelling. And the extant empirical work is limited, both geographically and in scope. For instance, most studies assessing changes in monetary transmission in low-rate environments focus on the United States.
Similarly, there is hardly any work assessing specific mechanisms. The field is wide open and deserves further exploration, not least given the first-order policy implications. Amy Wood provided excellent statistical support. The opinions expressed in this paper are those of the authors and do not necessarily reflect those of the Bank for International Settlements.
The numbers refer to the sovereign bonds represented in the Merrill Lynch World Sovereign index. It is not obvious why the exchange rate channel should be weaker, unless the link between changes in interest rates and the exchange rate is itself weaker. Yet the only serious inflation in this whole period occurred in the first decade. I am not saying we had no inflation at all.
Obviously, we did— and in many parts of the economy more than the CPI reflects. Some of it showed up in asset prices stocks, real estate instead of consumer goods. But there was nothing remotely like the kind of major inflation that this level of government debt should have caused. My good friend Lacy Hunt of Hoisington Investment Management presented two important theorems that explain this phenomenon. Federal debt accelerations ultimately lead to lower, not higher, interest rates.
Debt-funded traditional fiscal stimulus is extremely fleeting when debt levels are already inordinately high. Thus, additional and large deficits provide only transitory gains in economic activity, which are quickly followed by weaker business conditions.
With slower economic growth and inflation, long-term rates inevitably fall. That means the government—because it is the most creditworthy borrower—sucks up capital and leaves less available to private borrowers.
They must then pay more for it via higher interest rates or a weakened currency. Yet clearly it has not been the case for larger developed economies. That is not how most macroeconomic theories say debt-funded fiscal stimulus should work. Additional cash flowing through the economy is supposed to spur growth and in turn raise inflation and interest rates. One answer evokes the hypothesis of a liquidity trap [8]. Uncertainty is still prevalent, and the financial system is still so fragile that agents are continuing to express a preference for liquidity and safety, which explains their reluctance to undertake risky projects.
Thus, even if financing conditions are favourable, monetary policy will not be sufficient to stimulate a business recovery. This hypothesis probably explains the timidity of the recovery in the United States. But in the euro zone and the United Kingdom this hypothesis needs to be supplemented with a second explanation that recognizes the impact of restrictive fiscal policies in holding back recovery.
The euro zone countries, like the UK, are pursuing a strategy of fiscal consolidation that is undermining demand. While monetary policy is indeed expansionary, it is not able to offset the downward pressure of fiscal policy on growth. Since then it has reversed these decisions and lowered the key rate, which has stood at 0. The implementation of equivalent measures in the United States, the United Kingdom and the euro zone has contributed to greatly amplifying the interest in these issues.
Why has French growth been revised downwards?
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