A fall in the equilibrium rate, stemming from the preponderance of savings over investment, has risk of creating a loop, where low growth expectations can reinforce low investment activity and encourage deposits. The Ricardian Angst effect comes as another threat, suggesting that low interest rates can pressure people to save more in order to accumulate the same return as in a higher-rate environment. It is worth mentioning that this is not a solely theoretical approach – while no compelling evidence can allow us state that this is what has led to a surge in the gross savings ratio (17.5% in Germany and 14.4% in France), the trend is clear – and it should worry the ECB. The IMF has recognized the biggest Euro area economies entering a "low-growth trap", meaning that interest rates could dive even more, causing an even higher savings rate and ensuing notable threats of deflation.
Euro Zone Key Interest Rates
© Trading Economics
Traditionally, interest rates that are reduced below the natural rate - the natural rate being "a loan interest rate that reacts in an entirely neutral way to goods prices" (Wicksell, 1989) – should lead to boosted consumption which would result in an increase in aggregate demand. Increased demand encourages investment, and thus – expands demand for loans. In case there are not enough loans to satisfy the demand, an expansionary monetary policy comes to the rescue, filling in the gap. Ultimately, a cut in interest rates that creates a surge in investment should lead to a healthy dose of inflation. This, however, is not the case in the current economic environment.
A contraction in the equilibrium rate leaves the ECB with limited options, stemming from the restricted policy rate range. The current ECB policy consists of a zero percent key rate, complemented by a -0.4% deposit rate, and an asset purchase program that stimulates commercial banks to provide additional loans under more favourable conditions. The ECB inflation estimate lies at 1.8% for 2018, yet it leaves space for monetary policy to become subject to criticism from outside observers rooting for more effective macroeconomic stabilization programs.
Euro Zone Inflation
© Trading Economics
A discussion on better policy alternatives has emerged. Speculations over several options have not come to a consensus that there are conclusively better opportunities out there. The Meade proposal in 1978 implies that the expansionary policy following the crisis lacked scope, meaning that more measure had to be taken in order to battle a pre- and post-crisis GDP trend deviation. The approach has encountered severe opposition, noting problems with GDP data that requires revision, questions on how to communicate the policy to the public, as well as uncertainty over output, meaning that the inflation target could be met without boosting actual economic activity.
Flexible inflation targeting (FIT) is a dominant policy regime that emerged from criticism of ECBs primacy of price stability over other objectives, which has been set forth since the crisis. The approach proposes an integration of financial instability signs in the function of objectives, facing a discussion on whether these concerns should be in the competence of macroprudential policies. Besides that, critics doubt the capacity of monetary policy in addressing the economy with enough impact to bring back the previous trend.
While the current policy might indeed be the healthiest approach to the issue, it has its flaws spilled throughout financial, social and legal aspects of the economy. Banks, pension funds and insurance companies, especially those reliant on interest income the most, lose profitability on the low rates, private savers doubt the purpose of saving at the low rates at all. Fluctuations in portfolio returns, a shift in bank business models as well as the limited scope for future valuation gains could lead to a structural change of the financial system in general, highlighting new risks. New participants entering the sector, especially non-banks, could lead to lower lending standards, bringing risks of liquidity that could spill over into other sectors.
From the legal perspective, issues arise upon agreements that contain interest rate based remuneration, causing implications unclear both in regulation and private low in an environment of negative interest rates. Room for interpretation can lead to immense legal costs, in the case where clarification is needed.
Societal change is another factor that needs to be recognized when talking about a low-growth – high unemployment environment in specific economies. The flow of workforce, along with the refugee crisis and a belief of open borders providing benefits exclusively to large corporations with intentions to strip ordinary people from their protection rights, make globalization hard for groups that feel discriminated by the process.