The European Central Bank announced on Thursday that it is moving interest rates into negative territory, charging banks for maintaining deposits with the ECB rather than paying the banks positive interest. The hope is that lower (now even negative) interest rates may provide some stimulus to the European economy which might help bring European inflation closer to the ECB’s 2% target. Here I offer a few thoughts on this move.
Let’s start by clarifying what the measure will not do. The measure is not intended, as many people seem to suppose, to get banks to “lend out” their ECB deposits. The reason is that when an individual bank makes a loan or buys an asset, what they do is instruct the ECB to transfer the deposits from their account with the ECB to the bank of the counterparty who received the loan or sold the assets. The deposits of Bank A go down, but those of Bank B go up, with the result that some bank somewhere must always be left with those deposits at the end of the day. Actions by the ECB itself, or direct borrowing or cash withdrawals by banks from the ECB, could change the aggregate level of deposits that banks hold in their accounts with the ECB. But the lending and investment decisions of individual banks would not change aggregate ECB deposits.
But that doesn’t mean that individual banks won’t try to free themselves from this extra cost. If you know you’re going to be charged 0.l% (at an annual rate) for deposits you end up with at the end of the day, but see a 3-month government security paying say 0.2%, you’d want to buy the security on the open market. When Bank A makes that purchase, it gets itself out of a 0.1% loss and into a 0.2% gain. But Bank B receiving the deposits will realize that they’d also be better off using those deposits to get the 0.2% return, so they’ll also be buying any short-term securities that yield 0.2% in hopes of not getting stuck paying a fee on deposits. None of these efforts will change the fact that some bank somewhere will be left at the end of the day paying the 0.1% fee. But if all banks are out there trying to buy short-term government securities as a result of these incentives, what’s likely to happen is that the price of short-term government securities gets bid up above par. Once that happens, the 3-month securities effectively offer a negative return just like deposits with the ECB, and banks would be indifferent between buying the government security and getting stuck with the bill for reserves. For example, that’s what we saw happen to the 3-month yield when Denmark’s central bank implemented negative deposit rates in July 2012, an experiment that the Danes abandoned this April.
3-month Danish bond yield. Source: Investing.com
But if 3-month government securities only offer a negative return, banks might then also bid the yield on longer-term government bonds down, or be willing to lend to customers at lower rates or make higher-risk loans than they otherwise would, or try to buy assets denominated in something other than euros, driving the value of the euro down relative to other currencies. Again none of these efforts would change the aggregate volume of deposits, but instead would shift the entire constellation of returns to be consistent with the new -0.1% rate at the short end of the yield curve. The hope is that more borrowing, inflated asset values, and a weaker currency might all encourage more spending and ultimately help the ECB achieve its 2% inflation target.
Though speaking just for myself, an extra 10-basis-point spread on Greek debt relative to German bonds wouldn’t make me any more keen to be holding the former, despite the insult of taking a sure (but small) loss on the latter.
And of course there’s a fun game for an enterprising entrepreneur here. Offer a bank (or anybody else settling for a -0.1% return) a service where you’ll accept physical cash from them and hold it for 3 months for a 5-basis-point annual fee. You take the cash and simply hoard it for 3 months. You earn 50 cents on every $1000 over the year playing entirely with somebody else’s money. The bank gains too, being better off paying you 5 basis points than paying the ECB 10 basis points. The New York Times reported this quip on negative interest rates from Harvard’s Greg Mankiw:
the only thing you’ll generate is a demand for safe assets– and by that I mean . . . they’re going to be buying a bunch of safes so people can put their money in their safes rather than in the bank.
And there are some obvious downsides to the ECB’s strategy. For starters, it’s unambiguously a tax on the banking system that undermines efforts to replenish capital buffers. If you have concerns about financial stability, such a move is contraindicated. A variety of institutions– money market funds, customers’ accounts with private banks, brokerage accounts– are all set up on the assumption that the customers won’t lose any money held in those accounts. Remember that “breaking the buck”– the possibility that investors would discover they’re vulnerable to a capital loss on money market funds– was a key concern of U.S. policy-makers in 2008 as something that could have triggered a run on some financial institutions and instruments.
It may be possible that the measure matters more as a signal of future ECB intentions beyond the direct effect of lowering the short end of the yield curve by another 10 basis points. Certainly the mere announcement two years ago by ECB President Mario Draghi that he would do “whatever it takes” to preserve the euro seemed to have a pretty dramatic effect, even if nobody was quite sure what that expression meant.
This week I think we learned that it means, “whatever I can think of.”
Does the negative interest rate apply to all deposits at the ECB or only those above the amount they are required to keep due to reserve requirements? The former seems silly.
It’s only a tax on excess reserves.
would it be possible for a bank not to deposit excess reserve at ECB or they are forced to do it please? When you say “But the lending and investment decisions of individual banks would not change aggregate ECB deposits” are you referring only to deposit of reserves and excess reserves at ECB or to the total amount of deposits in the system? Thank you in advance for your answer
The negative rate is for the deposit rate, and also applies to excess reserves deposited at the ECB. So, it applies to more than just excess reserves. The ECB states that: ” 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.” See the ECB’s June 5th 2014 statement here: http://www.ecb.europa.eu/press/pressconf/2014/html/is140605.en.html
They are coupling the negative deposit rate with a loan incentive program. Don’t know if that will matter much. The negative rates are also only on excess deposits, so I’m not sure this has much meaning in any case. You’d have to price each bank’s excess deposit exposure, etc.
Denmark’s policy was explicitly, per Danskebank, to reduce pressure on the currency because it had attracted so much foreign investment. Their research says it had small effects but “the EUR/DKK moved back towards the central parity”, which was the main goal. They found no stimulus effects, strong performance in short-dated bonds (duh) and not much else.
There’s two ways of seeing this move: as a weak effort to devalue the euro, or a misguided attempt to boost inflation.
Compare what’s happened to the euro’s FX rate with what happened to the yen when Japan’s super QE and Abe fiscal stimulus were announced. The euro has mildly come down in the past month perhaps in anticipation. But it’s still in the same range it’s been in since last fall.
As for inflation, not even Japan has succeeded at that, really. The bump up in Japanese inflation is all cost-push related to the devaluation and hasn’t moved long-term expectations.
If you want to boost inflation, you’ve got to increase spending, and small changes in the interest rate curve just don’t do much in that regard. If the EU were really committed to a 2% inflation target it would have to abandon its fiscal treaty. Keep in mind that European economies have high import/GDP ratios, so the ability of each individual country to boost inflation is weaker than in a big country like the US. It’s not enough to blame German austerity. They would really need a big, coordinated fiscal stimulus to get inflation up to 2%. And that’s just not going to happen, I think for good reasons.
What’s more I question the value of boosting inflation from these levels. I don’t believe mild deflation is in and of itself a problem, although it is of course a symptom of weak growth or recession. If fiscal stimulus is worthwhile it’s to employ the unemployed and support general demand for producers hurt by unemployment-driven declines in demand. But the risks of confidence collapse in sovereign bonds markets are highest exactly where fiscal stimulus would help most, so I just don’t see it happening.
One thing people should remember when they opine about the EU. In the early American federation, up till the civil war, the federal government was small and yet there were no state-to-state bailouts. Nobody dreamed of it because it would have riled up resentment and torn apart the union. Not even after the civil war; the South had to pay for its own reconstruction with huge tax hikes. It wasn’t till the 1930s that the federal government became big enough to substantially shift wealth from one state to another. Even today that shifting is not really that big scale, and it’s fairly well concealed – it happens mainly through federal safety nets and federal support for state safety nets especially Medicaid. The process has been bureaucratized to a degree that these aren’t thought of as bailouts. If a local government comes asking for a specific additional bailout such as New York in the 70s or Detroit now, it’s likely to be told: drop dead!
A lot of editorial writers seem to think it would be easy for the EU to resolve the euro’s weakness by instituting automatic state-to-state fiscal transfers to stressed states. They claim that would be similar to the US system. It’s not, not at all. The US never never dreamed of any such thing, and wisely so or the union might not have lasted. The current US system is a large federal government. Prior to the 1930s, the states were on their own. Tough times meant fiscal austerity. It was sometimes ugly but it lasted long enough to allow the federal government to grow into what we have now.
Rules and regulations both promoting and preventing growth can result in expensive no growth.
U.S. monetary policy has been much more effective than Japan and the E.U..
Japan began QE very late, in response to demographic shifts, while the ECB hasn’t implemented QE, perhaps, because of the “PIIGS.”
The Fed acted quickly and decisively, although it was somewhat behind the curve easing the money supply, initially, in 2007 and 2008.
The Bernanke Fed deserves a lot of credit (pun intended). Unfortunately, fiscal policy and economic policies out of Washington have been less effective and counterproductive.
I’m starting to wonder if the primary determinant of inflation is the growth rate of the workforce, and all these efforts to whip up even 2% inflation are mostly ineffective and comical.
http://www.bls.gov/opub/working/page1b.htm
Can we have full employment (everybody who can work and who wants to work can find a reasonably decent job) in a low-growth, zero inflation economy of the future?
To get an adequate amount of inflation you might have to subsidize interest paid (“print” money) on checkable deposits for private individuals and companies.
You really could make the same argument after every recession, since banks are low on capital after a period of high defaults, and recessions. Banks surely could replenish capital faster if short rates were higher after a recession. Except, not: bank earnings = capital, and banks don’t make money on short term securities, they make money lending long term. Nor do they make money on govt bonds. They make it lending into the real economy. Govt bonds and short term securities are a necessary evil at a bank.
The impact on bank capital from negative rates is indeterminate, but most likely positive for the same reason low rates always increase capital: the market value of assets (loans, mostly longer term) goes up. Higher-than-expected loan defaults are what eats capital.
Bank pricing/risk models are by and large backward-looking. Lending tends to looks more risky when we have been through a period of high defaults (and vice versa). Negative rates will do what low rates always do, push banks to reach for yield in (real) lending, which will build earnings and capital. You cannot really build capital on short term securities, no matter what part of the cycle you are in.
High unemployment and low aggregate demand cause loan defaults (reducing capital) and banking failures. “banking stability” is synonymous with macroeconomic stability. Loans are in nominal terms, too, so if you want banking stability, think of a way to keep unemployment and personal income stable. Hmmm.
10bp, no. 25bp, still no. But it’s like the old joke – there is some price at which the average market participant would swap. The question is, what is the price, and whether the ECB is committed to doing it. If this was the only the first step, it was a good one. If it was a last step, well, its another failed experiment.
The economy of the US and Europe will only improve when the central banks stop being afraid of 2.5% inflation. To get 2% inflation, they need to risk 3% inflation. Right now, 2% is really a ceiling.
First off, I’m amazed at the clarity you consistently bring to these issues. You are by far the best in the econoblosphere at meaningful and clear explainations of these topics. I do have issue with one thing from this still succinct post. You say “Let’s start by clarifying what the measure will not do. The measure is not intended, as many people seem to suppose, to get banks to “lend out” their ECB deposits.” However, a good portion of the remaining post goes on to describe negative rates as an incentive for banks to “lend out” their ECB deposits. Just my thoughts. Thanks for the post.
Yes, I noticed that, too.
“The deposits of Bank A go down, but those of Bank B go up, with the result that some bank somewhere must always be left with those deposits at the end of the day. ”
If the borrower plans on using the debt to buy a bullzdozer then the money in Bank B get spent, and do not remain as deposits, no?
Hans: If the borrower takes the funds now deposited in Bank B to buy a bulldozer, said borrower writes a check to the seller of the bulldozer, who has an account with Bank C, and the deposits end up there.
All you can do with an ECB account is order the funds to be transferred to somebody else’s ECB account, so the funds never disappear.
It’s like paying cash for something. If you get spend your cash, that doesn’t make the physical currency disappear, it just means somebody else is now holding it.
JDH:
I understand this. My initial point was that some reads may be confused with the line: “The measure is not intended, as many people seem to suppose, to get banks to “lend out” their ECB deposits”. However, this is not true as you later state: “…..be willing to lend to customers at lower rates or make higher-risk loans than they otherwise would”. Even if the aggregate doesn’t change, that doesn’t mean negative rates aren’t (in part) introduced to induce additional lending. Again, just my two cents & a nit-pick on clarity (something that 99.999999% of the time is a distant afterthought with your writings).
I think this is a good point and not just a nit-pick. The ECB is trying to get banks to lend out their reserves. It is not trying to get banks to collectively shed their aggregate reserves.
Not if it’s a foreign purchase, which over several decades will eventually result in a devaluation of the currency. I bet we see some capital flight, not to people’s mattresses or gold or bitcoins, but to American, Canadian, or Japaneses institutions.
JDH has somewhat simplified the situation. If you substitute ESCB, the European System of Central Banks, for ECB in JDH’s explanation, it’s more technically correct. Euro Area banks don’t really keep their reserves at the ECB. They keep them at Euro Area national central banks, which are part of the ESCB.
If you mean an intra-EA foreign purchase, the euro reserves move from one EA country’s NCB to another EA country’s NCB. If you mean an extra-EA foreign purchase, the euro reserves still stay within the ESCB and might not leave the NCB. When euros are transmitted to a non-EA bank, the euro reserves go to the NCB that serves the EA bank that holds the non-EA bank’s euro correspondent account. Euro reserves by definition can’t leave the ESCB. The only way euros really ever leave the euro area is as euro notes.
Banks and S&L’s also have to pay deposit insurance, which has led some banks to effectively present savers with negative interest rates. Things like max deposits charges for balances that exceed certain thresholds as well as the longstanding practice of charging fees for balances that fall below minimum levels.
Is there a restriction on banks holding vault cash? If not, wouldn’t they just convert all excess reserves to cash to avoid the negative nominal interest rate? That, of course, ruins the “fun game” of getting banks to pay you 5 basis points to hold the cash, since they could just hold the cash themselves. Then the interesting thought experiment would be that there would be excess demand for cash, causing the price of currency to rise above it’s face value when paid for in demand deposits.
The experience in Denmark was they paid the negative rate. The negative rate would have to be bigger to make cash worthwhile. Besides the cost of securing cash, it’s a lot more expensive to securely deliver to another bank.
It can’t do any harm but it’s not the best way to get the inflation rate into the 4%-5% range.
My worry about negative interest rates and their consequence throughout the yield curve is expectations. It would seem as though you have reached, or are damn near, to a point where you can only expect this to be reversed and rates to only go up. Thinking about long term finance such as mortgages or car loans: why would a lender lend? And who would take a variable rate loan? On a more general level, isn’t it wrong for the ECB (or any CB) to create situations for one-way bets?
I wonder if Menzie is as big as Christine Legrande of the IMF.
Lagarde Says IMF ‘Got It Wrong’ on Rallying U.K. Economy
While the US was claiming a 0.7% growth rate in the first quarter of 2014, the IMF was forecasting at 2.3% growth rate for the UK. Subsequently the US revised its growth rate down to -1%. The IMF has now also revised the growth rate of the UK, UP to 2.9%, the highest growth rate of the Group of Seven.
The IMF notes that the austerity of the UK actually worked, but they miss other positive moves in UK finance. Most significantly the relative stability of the pound sterling. In 2010 while the dollar was soaring due to Bush TARP and Obama QE the pound maintained its value and appreciated significantly agains the dollar. After the FED began to stabilize the dollar the pound-USdollar returned to an exchange rate of around $1.60. That has been the rate for over 5 years.
On the issue of taxes the UK increased its VAT tax from 17% to 20% and the shock sent the economy reeling. But on taxes the UK has been significantly restrained. The drop of personal rates from 22% to 20% in 2010 was a significant offset of the increased VAT tax and corporate taxes have been significantly stable. The primaty source of income to the UK is the income tax but second is the National Insurance tax (a warning about Obamacare) but this tax has also been stable for a number of years allowing traders to adjust to the system.
The UK government has been non-interventionist for some time allowing the economic climate of the UK to remain stable. By cutting governent spending and staying out of the way of the economy the governemnt has created an environment of growth in the UK. What do you believe the chances are that the Obama administration will leave from the UK experience? Probably about the same as Menzie following the lead of Christine Legrande.
I meant “the Obama administration will learn from the UK.”
since 2007 the US GDP growth rate had exceeded the UK growth rate in every quarter except 3. In aggregate the US GDP growth since 2008 (peak year) has been +10% and the UK growth since then has been -15%.
( http://www.tradingeconomics.com/united-states/gdp )
Is it possible that the US doesn’t have so much to learn from the UK?
bell
I was wondering why you pick way back to 2007 for your analysis? So I looked at your link and found that 2010 was the year of the start of the turnaround for the UK, the same year that “austerity” policy was announced. I am not sure of your point, but if it is the the UK is now benefiting greatly from a more realistic fiscal policy than I am in complete agreement.
Ed
If I read tradingeconomics’ charts correctly, the US’s growth rate has averaged about 2.25% from 2010-2014, while the UK has averaged about .3%.
That doesn’t seem like a recommendation for the UK’s economic policies.
bellanson,
Yes, the UK tax policy has been a drag on the UK economy – something I pointed out when Menzie began his attacks against UK “austerity” – but as long as they leave taxes alone, or even cut them, their recovery will continue stronger than the zero interest rate/QE economy of the US. Never forget that the US overwhelmed the UK’s economic world leadership in the 19th Century by growing at 4% while the UK grew at 3%. It looks like the UK is poised to return the favor.
Note: Do not fall for the FED-speak concerning Tapering. Tapering is not reversing QE. Tapering is simply reducing the rate of increase in QE. The FED has taken a page from the congressional play book where a decrease in the budget is when the congress INCREASES the budget but less than they originally planned to increase it. The FED is expanding the money supply only less than they planned so, voilà, Tapering.
When the US economy crashed into negative growth in early 2014 the pundits who were so wildly wrong in their predictions all blamed the weather and claimed that the economy would recover in the second quarter when things warmed up. Well the economy certainly has not warmed up in the US. All the prognosticators seem to be rushing to be the first to downgrade their predictions.
Here is the take by the IMF and others.
You say: “None of these efforts will change the fact that some bank somewhere will be left at the end of the day paying the 0.1% fee.”
I don’t believe this is true. As the banks lend out funds then the excess reserves become required reserves and no longer subject to the 0.1% fee (on excess reserves). It is true that aggregate reserves are unchanged, but the distribution between required and excess changes.
A similar point was made on David Andolfatto’s blog with some additional detail:
http://andolfatto.blogspot.com/2014/06/excess-reserves-and-inflation-risk.html?showComment=1403567355657#c3691358312579039900
And it is clear that you know the difference given your comment on June 7 (“It’s only a tax on excess reserves.”), but I believe the post is still confusing.