ECB Research Bulletin: See Potential Side Effects of Monetary Stimulus When Rates Already Low

22 September 2021

By David Barwick – FRANKFURT (Econostream) – Authorities need to be careful of the possible unintended consequences of cutting interest rates further when these are already low, according to a research bulletin published Wednesday by the European Central Bank.

‘Our research suggests that there are potential side effects of monetary stimulus in a low interest rate environment: reduced lending and increased risk-taking by banks’, the bulletin said. ‘As a result, it is important for central banks to take financial stability considerations into account when deciding on monetary policy, since there may be conflicts in the long run between price stability and financial stability.’

‘Moreover, our modelling framework suggests that the competitive nature of lending and deposit markets needs to be taken into account when assessing these trade-offs’, it added.

Low or negative interest rates could both hinder lending and lead banks - which can’t as easily shift the cost of a policy rate cut to depositors - to take more risks, the bulletin said. Left with a reduced interest rate margin that cuts into profitability, banks may respond in various ways: scaling back lending to remain compliant with regulatory requirements, lowering standards or opting for riskier investment strategies to boost returns, it said.

The authors of the bulletin set up ‘a simple conceptual framework to show how a policy rate cut affects both bank lending and risk-taking in a low or negative interest rate environment versus a high interest rate environment.’

They concluded that ‘central banks and banking supervisors should exercise caution’ about monetary easing in a low interest rate environment.