The risks of low interest rates

Gambacorta, Leonardo

The risks of low interest rates

Revista Ensayos Sobre Política Económica; Vol. 29. No. 64, edición especial Riesgos en la industria bancaria. Julio, 2011. Pág.: 14-31.

Date published

2011-07-01

Date

2011-07

Authors

Gambacorta, Leonardo

ISSN

0120-4483

Document language

eng

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Las opiniones contenidas en el presente documento son responsabilidad exclusiva de los autores y no comprometen al Banco de la República ni a su Junta Directiva.

The opinions contained in this document are the sole responsibility of the author and do not commit Banco de la República or its Board of Directors.

Abstract

At present, monetary policy in major advanced economies is highly accommodative; policy rates are close to zero and unconventional monetary measures have been sharply expanded. However, the recovery remains fragile and the policy discussion has shifted from exit timing to the possible distortions that a prolonged period of low interest rates may cause. In addressing the latter issue, this paper examines how far an exceptionally easy monetary policy may have unintended consequences for financial stability. The main channels by which monetary policy may influence risk-taking have been widely investigated (Borio and Zhu, 2008). There is, however, less evidence for the possible medium to long-term consequences of prolonged periods of policy rates close to zero and the extensive use of balance sheet policies (Borio and Disyatat, 2009; Del Negro, Ferrero and Kiyotaki, 2010). This paper suggests four possible ways by which a prolonged period of low interest rates could create distortions, by: a) inducing "evergreening policies" and postponing necessary adjustment in banks’ balance sheets; b) making bank profitability particularly vulnerable to future increases in interest rates; c) distorting the allocation of savings and the functioning of financial markets and d) influencing capital flows to emerging markets and creating pressure on exchange rates.