- From zero interest rate policy to negative interest rate policy. The ECB's landmark decision shows just how desperate they are to avoid deflation.
- The worst-case scenario of the ECB's negative deposit rate case is that it causes a new round of toxic credit lending by banks who want to avoid the fee.
- ECB's decision to go negative on the deposit rate just makes it easier for PIGS and struggling European governments to borrow more money.
Gold has been stealthily creeping up against the dollar as we head into the doldrums of summer trading (low volume and low volatility). But last week was chock-full of noteworthy stories to report on. Number one has to be the European Central Bank's decision to boldly go where no major central bank has gone before; into negative interest rate territory. Here are the details from the official transcript Mario Draghi read last Thursday.
"First, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.15% and the rate on the marginal lending facility by 35 basis points to 0.40%. The rate on the deposit facility was lowered by 10 basis points to -0.10%. These changes will come into effect on 11 June 2014. The negative rate will also apply to reserve holdings in excess of the minimum reserve requirements and certain other deposits held with the Eurosystem."
The forceful suppression of interest rates by central banks is by no means a new policy. The last century is replete with examples of the abuse of this power and its corresponding consequences. Of course, the central bankers see it as a principle tool to achieve their mandate of "price stability." Keynesian and monetarist economic theory have given them the academic "green light" to do this. We have made the case again and again that ZIRP (Zero Interest Rate Policy) and QE lead to anything but stability. Rather, they are on the whole a destabilizing institution injecting needless and destructive volatility into markets.
ZIRP is inherently inflationary, punishing savers by taking away any yield on money, thus forcing them into increasingly risky speculative bets to try and gain a return. Nor can we forget the principle role ZIRP plays in engendering the dreaded boom-bust business cycle. While both the US and the eurozone have been frolicking in ZIRP land for the past 5 years, last week's decision by the ECB to cross the border into negative territory marks a historic event and shows just how far central banks are willing to go to achieve their goals.
Why negative interest rates?
This is really the same as asking why the ECB and the Fed have been pursuing ZIRP in the first place. What are they after?
The stated answer that Draghi (and Yellen) have given is that they want a higher inflation rate.
"Together, the measures will contribute to a return of inflation rates to levels closer to 2%."
Central banks are pursuing inflationary policies because they are terrified of deflation. To them, deflation is simply a general fall in aggregate prices. They point back to the Great Depression in 1933 as a particularly bad spot of deflation. One which they would very much like to avoid. The 2007-2008 financial collapse serves the same purpose. That is why they intervened shortly after with extraordinary and unconventional measures (TARP, ZIRP, Bailouts, QE, etc.) to prop it all up again. They obviously do not want prices to fall. They want prices to rise, all of them, from stocks to bonds to salaries to consumer goods. They want the wealth effect to take hold. They don't care if you can't buy as much today as you could 50 years ago with the same amount of printed paper (or electronic deposits, for that matter). Prices are going up. That is all that matters.
They hope to achieve this goal by expanding the total supply of credit, getting more euros (dollars) in the hands of more people with the hopes they will spend those euros on something, thus raising the price of that something. ZIRP does this, as it lowers the overall cost of lending. It serves as an enticement and incentive to get people to bite. It's not that different from holding candy in front of a kid, hoping he will take it.
Negative interest rates go one step further. Now you will have to pay if you keep your cash on the sidelines. Just like in the US, European banks are sitting on large piles of reserves. These are not being lent out. Draghi thinks they should be, and if ZIRP is not enough of an enticement, then perhaps charging them to play it safe will do the trick. To keep up with the analogy, this would be equivalent to spanking a kid for not doing what you want them to do.
What are the implications of a negative interest rate?
The answer is simple enough. Negative interest rates mean the bank actually charges you to keep your cash on account with them. If the interest rate is -.10%, like in the above transcript, then for every $10,000 you keep on deposit at the bank, you will be paying $10 a month to do so. Over the course of a year, only $9880.00 would remain from your initial deposit. Normally, banks will offer customers positive interest as an incentive to loan them their money. While this is still true today, you may have noticed the gradual disappearing of interest offered. Most rates today are next to nothing. This is because we are in ZIRP land. For members of the eurozone, though, it is about to get worse. While this move into negative territory is only on a special rate (the deposit facility rate, which is the equivalent to the overnight interbank lending rate on deposits that the Federal Reserve sets) offered only to large, privileged investment banks like Deutsche Bank, for example, it will still serve to drag down all other rates.
Will it actually work?
Of course, banks are not kids. Neither are business owners. They are much smarter than that. They do not always respond uniformly the way central banks want them to. This instance is no different.
Draghi's decision to go negative on the deposit rate will not achieve the desired result. Rather, as in all cases of central planning, this decision will have unintended consequences. Let's look at a few.
Firstly, the credit market, like any other market, is at least a two-way exchange. Simply expanding the total supply of credit is only half of the intended exchange. It will continue to sit there unless adequate demand arrives. In Europe, just like in the US, the state of the credit market is saturation. Remember, we are 5 years into ZIRP land. Credit has not been particularly hard to come by. Corporations and individuals have been trying to restore their balance sheets, getting rid of bad debt, and getting back to solvency since 2008. Thus, banks having been lending very little, and are sitting on piles of reserves, which is what Draghi hopes to spank into lending. But spanking banks does not magically make corporations or individuals creditworthy.
For many, it simply does not make sense to go back into debt when they are still coming out from under the first (or second) wave. This is especially true of the fringe countries of the eurozone. Businesses are not thriving there, unemployment is still rampant. Are those countries really ready to take on more debt?
To help understand the dilemma, put yourself in the bank's shoes. If you are deciding between having to pay .10% to keep your capital risk free or between lending it out to somewhat less creditworthy institutions which are already struggling to pay off prior debts, which one would you choose? A simple cost-benefit analysis might lead many a bank to say, "There really is no good alternative here, but the least bad alternative is actually paying the .10%. We might end up losing a lot more if we extend credit only to have our client default later." At the end of the day, charging negative interest rates might not do as much as Draghi hopes.
And if the banks take the bait?
Alternatively, and let's pray this is not the case, charging banks to stay safe provides the perverse incentive to make banks lend where they shouldn't be lending at all! This would be a most dire result of the ECB's decision. Banks, being punished to play it safe, might start playing it dangerously. They will start lending to whomever they please, solvent or insolvent. Savvy speculators will see opportunity in this, and will start packaging junk debt in seemingly attractive secure bundles to make a quick buck selling it to the banks. Since the banks are in a sense being forced to lend (if they don't want to pay), the likelihood they will rigorously review the creditworthiness of their borrowers is lower. Negative interest rates make it increasingly costly for the banks to use discretion in lending. This could potentially introduce an entirely new round of toxic debt into the marketplace, with even greater potential for default. That is not good.
Secondly, even if the banks lend out their reserves, as Draghi hopes, many of them will end up right back in the banking system. Keith Weiner has a great article for Forbes, where he brings up this point.
"Cash never leaves the banking system. It is a closed loop, with money transferring from one party to the next, but always remaining in the custody of a bank. Lending does not avoid the need to deposit cash at the ECB, or in the US, at the Federal Reserve."
Of course, Draghi wants this money to ultimately get in the hands of someone who can spend it. But the reality is that the vast majority of it will never even make it there. Think about it. When you borrow money from a bank, does the bank actually give you the total sum in cash? In stacks of colorful paper? No! What you actually receive from the bank is a notation that you have increased credit from the bank in your account. Nothing goes in or out from the bank. It all stays right there. This is as true for large-scale financing as it is for you and me. Lending does not avoid the need to deposit cash at a bank.
What is more likely to happen.
There is a third scenario and consequence of Draghi's decision which has already started to play out. On the surface, banks may seem to be stuck between a rock and a hard place (punished to keep reserves on deposit, and at the same time, without creditworthy borrowers), yet there remains one way for them to avoid paying the ECB, and it's virtually risk-free; buying government bonds.
The banks can buy public debt, happily provided by none other than the ECB, and escape the fee. The ECB, who receives the cash, is not under the same restrictions as other commercial banks in terms of holding deposits, and is certainly not going to charge itself for doing so (although who knows what Draghi might do next). Indeed, this has already begun to happen. (Keith Weiner predicted it would, in his article.)
The interest rate is inverse to the price of the bond. If banks are buying government bonds, this will bid up the price of the bond and push the interest rate down. Has anyone checked the yields on 10-year sovereign bonds since this announcement? Here are a few to make the point.
Spain's 10-year Bond
Italy's 10-year bond
The results of Draghi's decision will not lead to an increase in prices or get closer to the targeted inflation rate. It will not spur new business or increased consumer spending. It will lead to an ever-lower interest rate on government debt, which will allow already insolvent governments to borrow more money and more easily rollover their existing debt obligations. When one stops to think about it, one has to ask, was that the real reason why the ECB decided to do this in the first place? All that talk about inflation might just be a pseudo-academic cover-up to disguise the real objective: making it easier for governments to borrow more money.