The ECB Goes Negative – What Does it Mean?

The ECB introduced a negative deposit rate overnight at -0.10% from the previous rate of 0%.   In addition, they introduced a new €400B longer term refinancing operation with a 4 year term.  Let’s break this down in simple terms:

• The negative rate is on excess liquidity deposited at the ECB, NOT necessarily the rate that savers earn on deposits.   This means the banking system as a whole is now being effectively taxed to maintain liquidity at the ECB.  The hope is to reduce rates further, entice some lending, etc.

 

• This doesn’t mean lending rates or other bank costs won’t increase though.  In fact, as this negative rate acts as a direct tax on banks it’s very likely that they will simply try to pass the cost on to consumers.

Will it work?  

• This has been done before, but not in similar circumstances.  For instance, the Danish Central Bank set a negative rate in 2012, but that was under very different circumstances because the Krone is pegged to the Euro and the negative deposit rate was primarily a foreign exchange rate policy.  Still, there were no discernible positive economic benefits from this policy in Denmark.

 

• The negative rate should cause further reach for yield which means that interest rates should ease a bit as demand for higher yielding alternatives increases.  This has been problematic across much of Europe as market rates have not directly followed the overnight rate.  That said, it’s hard to imagine that a 0.1% move in rates is going to make a colossal difference.

 

• The negative rate could induce some lending as banks potentially loosen standards to offset the lost interest income.  But lending is primarily a demand side function so it’s unlikely that this will drive lending to a large degree given that this policy will not increase demand for loans on its own.

 

• There are the obvious behavioral effects.  The ECB has vowed to do “whatever it takes” and has proven that they will continue to press on the issue until there appears to be a resolution.  It’s impossible to quantify what this behavioral effect is, but there’s no doubt that the commitment to an accommodative policy is more beneficial than an alternative.

 

• This could all feed into FX markets as higher expected growth fuels higher FX rates.   But the effect here is probably overstated given that the Euro is a closed system and the current account deficit countries that would most benefit from FX changes (the periphery) would prefer to see lower FX rates and not a higher Euro relative to other currencies.

 

• Given that this is being implemented along with a further commitment to the LTRO program, I think this policy is probably pretty neutral for the banks as a whole and is a further sign of commitment by the ECB.  That should be seen as marginally positive if anything.

Conclusion

I don’t think this is a huge deal.  In fact, it’s probably more experimental than anything else.  The meager size of the rate cut tells me they’re toying with the policy and seeing what the near-term impact will be.   The more important policy change is probably the longer term refinancing operation and the ECB’s commitment to continue providing liquidity.