The Reversal Interest Rate: The Effective Lower Bound of Monetary Policy

Citation:

Brunnermeier, Markus K., and Yann Koby. “The Reversal Interest Rate: The Effective Lower Bound of Monetary Policy”. (In Preparation). Print.

Abstract:

The "reversal rate'' is the rate at which accommodative monetary policy "reverses'' its intended effect and becomes contractionary for lending. It occurs when recapitalization gain from the duration mismatch are offset by decreases in net interest margins, lowering banks' net worth and tightening its capital constraint. The determinants of the reversal rates are (i) banks asset holdings with fixed (non-floating) interest payments, (ii) the degree of interest rate pass-through to loan rate and deposit rate, (iii) the capital constraints that they face. Low interest rates beyond the time when fixed interest rate mature do not lead to recapitalization gains while still lowering banks' margins, suggesting a shorter forward guidance policy: the reversal rates ``creep up". Moreover, interest rate cuts can have heterogeneous effects across regions where monetary policy operates, being possibly expansionary in one region and contractionary in another. Furthermore, quantitative easing increases the reversal rate. QE should only employed after interest rate cut is exhausted.

Last updated on 05/03/2017