20 September 2017
Mario Draghi, president of the European Central Bank.
Photo: Bloomberg
Mario Draghi, president of the European Central Bank. Photo: Bloomberg

Eurozone’s negative interest rate scenario

The European Central Bank’s Governing Council is unanimous in not accepting current low inflation and in being ready to implement unconventional measures. ECB president Mario Draghi has said so more than once.

A number of potential measures have been discussed. Let’s look at the imposition of negative interest rates on banks’ deposits with the ECB.

It is perhaps first necessary to establish what interest rates would not do. Occasionally, proponents of negative interest rates on banks’ deposits with the central bank seem to believe that these reserves make up a sum of money which, if not parked with the central bank, could be used to lend to the non-bank private sector.

This is, of course, not the case. Banks’ reserves with the ECB were created by the ECB when it lent money to those banks or bought assets from them. They are, as it were, an investment by the banks.

If they were not parked with the ECB, they would be used to invest in something else, most likely some form of financial asset. But, apart from their impact on the balance sheet size, they have no bearing whatsoever on a bank’s decision to extend credit to the non-bank private sector or not. That can be done regardless of how big or small a bank’s reserves with the central bank are.

What negative interest rates could do, is twofold. They could affect the exchange rate of the euro, and they could cause banks to allocate their assets differently.

In essence, if the ECB were to introduce negative interest rates on banks’ deposits – presumably on excess deposits – with the ECB, banks can react in a number of ways, one of them is changing their asset allocation.

Banks can alter their asset allocation by using the reserves to purchase other assets. Since the banking system as a whole by definition cannot achieve this by buying assets held by banks, this means buying assets from non-banks. In other words, it is a de facto quantitative easing at arm’s length. This would clearly be good news, although it depends to some extent on what assets the banks buy.

If banks concentrate on buying government bonds or bills from the issuer or assets from each other, there is no effect on broad money and little enough on activity. By contrast, if they were to buy assets from the non-bank private sector – public or private bonds or bills, equities, etcetera – this would have an immediate effect on the stock of broad money. (Banks’ reserves with the central bank are not part of broad money, whereas deposits by households and non-financial companies with banks make up the bulk of broad money.) It would tend to cause the sellers to buy other assets, thus driving up asset prices; or create further activity if they spent their new funds on goods and services.

Assuming that all of these reserves were reallocated this way, the impact on inflation is estimated to be minimal – at most 0.2 percentage points.

It is therefore far more likely that the impact of negative interest rates would come through the exchange rate. However, it is not clear how much negative interest rates affect a currency.

The only two recent examples of negative interest rates on banks’ deposits with the central bank are Sweden from July 2009 to September 2010, and Denmark from July 2012 to April 2014

In the case of Denmark, the krone had risen above its target rate of 7.46038 per euro. While it remained within the official 2.25 percent band, as well as within the actually applied 1 percent band, the Nationalbank was concerned about currency strength. Following the introduction of negative interest rates, the krone fell from a peak of 7.4326 in June 2012 to 7.4616 in January 2013, a fall of 0.4 percent.

Applying the Danish results to the eurozone without adjusting them would imply that negative deposit rates would make the euro fall by less than one US cent; and that MFIs would perhaps reallocate about €50 billion of their reserves. Neither of these results is very impressive.

All in all, it seems that the impact of a move to negative interest rates will be limited, not to say minimal. But, in any case, even a small impact would be better than none.

In addition, we are assuming that the ECB will also implement other measures – including, hopefully, some kind of direct quantitative easing and possibly also ceasing to sterilize the Securities Markets Program. In that case, the cumulative effect could well be greater than each individual measure by itself.

The writer is Director, Asset Management Services at Oxford Economics

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Director, Asset Management Services at Oxford Economics

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