The European Central Bank's Negative Interest Rate: Doubts that it can resolve the credit squeeze

Since the start of the year, the U.S. Federal Reserve System (Fed) has gradually tapered back its third round of quantitative easing (QE3), a policy that includes purchasing long-term government bonds and mortgage-backed securities. The outlook is to eliminate purchases by the autumn and return to conventional policies based on bank rates (the Federal Funds rate). In contrast, the European Central Bank (ECB) has adopted a monetary policy that is a step behind that of the Fed.

One reason for the delay was the financial crisis that hit the eurozone, especially Greece and other southern European nations in 2010, as the global financial crisis spread. Putting financial safeguards into place also took longer than expected; the establishment of the European Stability Mechanism (ESM), for example, was delayed until October 2012. Economic recovery in the eurozone has lagged behind that of the United States for these reasons.

The appreciation of the euro versus the U.S. dollar and the Japanese yen, a by-product of monetary easing by the Fed and the Bank of Japan (BOJ), has weighed down the eurozone economy.

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In contrast to the Fed and the BOJ, the ECB has adopted a policy of ultra-low interest rates, but until now, those rates had not fallen to as low as 0%. Even the ECB's quantitative easing has been limited to a three-year long-term refinancing operation (LTRO).

On June 5, 2014, however, the ECB announced a new monetary easing package, which went into effect on June 11, 2014. The real economic growth rate for the first quarter of 2014 had fallen to just 0.2%, while the May inflation rate, at 0.5%, was lower than expected. Business loans continued to contract and were down 3.1% year on year in March and 2.7% in April. The ECB's moves, therefore, can be considered as a way to keep the economy and prices of goods from declining further.

The package consists of four parts. The first part is to lower the key interest rates. The second is a targeted long-term refinancing operation (TLTRO) worth 400 billion euro over four years. The financing that banks receive will depend on how much they lend. The intent is to boost bank lending to households (other than mortgage loans) and businesses.

Third, the ECB decided to intensify preparatory work related to purchasing asset-backed securities, and fourth, the ECB gave forward guidance that it would continue to provide short-term and long-term refinancing at fixed rates through at least December 2016.

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The first measure, lowering the key interest rates, includes lowering one of the three types of interest rates to less than zero. This stands out because loans are now available at a negative interest rate.

The ECB lowered its refinancing rate on short-term financing by 10 basis points, from 0.25% to 0.15%. It dropped its marginal lending facility rate (the upper end on short-term interest rates) from 0.75% to 0.40%. At the lower end, in turn, the rate on deposit facilities (where commercial banks deposit money with the ECB) fell from 0% to -0.10%. The spread of the ECB's three rates, called the "corridor," changed in unison.

Except in a few places such as Denmark in the past, negative interest rates are largely unprecedented and came as shocking news. However, the ECB has no choice but to set a negative rate for deposit facilities. Inflation had been falling far below the medium-term target of 2%, leading the ECB to set the negative rate in an attempt at economic recovery.

Moreover, the ECB understands that it must not set the three key interest rates too close to each other, because adequate spreads is what allows the interbank market (i.e., lending and borrowing between banks) to function. The deposit facility rate had been 0% when the ECB lowered the refinancing rate by 10 basis points. As a result, it became necessary to lower the deposit facility rate by the same 10 basis points to maintain the corridor.

Deposit facilities give banks a place to temporarily deposit their surplus funds to keep monetary control working smoothly. In this case, the negative rate applies not only to funds placed in deposit facilities, but also to excess reserves that are greater than the minimum reserve deposits that banks are legally required to keep in ECB current accounts. By implementing this policy, the ECB aims to restrain banks from depositing excess funds, broadly speaking, at the ECB.

Negative interest rates also apply widely to government deposits in the Eurosystem beyond a certain threshold, to the Eurosystem's reserve control service accounts, to account balances in the TARGET2 payment system, and more.

Will a negative interest rate strengthen the transmission mechanism from monetary policy to the real economy and enhance monetary policy effectiveness? Consider the fact that a negative deposit facility rate will make banks pay to deposit funds with the ECB. If banks wish to avoid this cost, they will try to draw down the excess deposits they have at the ECB.

On the other hand, banks will weigh the credit risk of lending to businesses and the sovereign risk in some eurozone countries against risk-free deposits at the ECB. If they think of the negative interest inversely, in terms of a risk premium, and decide that the asset management risk matches the returns, it is not necessarily the case that banks will reduce their excess ECB deposits.

There are other problems as well. Even if banks draw down their excess deposits as the ECB expects, will this resolve the credit squeeze so that banks use the money to finance businesses? And will the latent financing demand on the business side increase?

Banks bear financial risk whether they make loans for businesses or invest in government bonds, but government bonds come with relatively less risk, and investing in such government bonds is still an option for banks. At the same time, businesses' financing demand is unlikely to grow significantly given the eurozone's economic stagnation.

This pessimistic view is backed up by the fact that interest rates on government bonds in most eurozone countries fell immediately after the negative interest rate was announced. This means that government bonds were being purchased speculatively in hopes of growing in value, in the expectation that banks either have already started buying government bonds with their excess deposits at the ECB or plan to do so.

On the other hand, in the so-called GIIPS (Greece, Ireland, Italy, Portugal, and Spain) countries that are facing serious fiscal crises with high levels of government bonds relative to gross domestic products (GDP), yields on government bonds have dropped by more than 10 basis points. In this respect, the ECB's latest measures have contributed to a further lowering of the already diminished premium on sovereign risk in the GIIPS.

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It is questionable whether loosening the credit squeeze at banks will really strengthen the monetary policy transmission mechanism when businesses have such slow financing demand. As this article has pointed out, it seems the ECB's negative interest rate helped lead to a slight diminishing of sovereign risk premium.

On the other hand, purchasing asset-backed securities (to name an alternative transmission mechanism) potentially could increase asset prices and improve banks' balance sheets. At the same time, the ECB could help change people's expectations of inflation if its forward guidance were changed. Specifically, instead of saying that the ultra-low interest rates in effect until now will continue, the ECB could promise that not only ultra-low interest rates but also quantitative easing would continue until inflation reaches 2%. Means such as these would reinforce the monetary policy transmission mechanism and bring the ECB closer to the quantitative easing policies of the FRB and the BOJ.

Economies cannot easily escape deflation once they fall into it. Along with providing the right forward guidance, unless the ECB unhesitatingly endorses quantitative easing that includes buying asset-backed securities, it may be too late for the eurozone to free itself from its poor economic conditions and deflation.

>> Original text in Japanese

* Translated by RIETI.