Will the European Central Bank’s negative interest rate be an economic positive?
Last Friday marked what we in the United States affectionately call “jobs day,” when the monthly release of unemployment data is closely watched to predict whether the central bank will continue dialing back its monetary stimulus. But across the pond, last week brought the unveiling of an unprecedented monetary policy decision by the European Central Bank.
On Thursday, European Central Bank President Mario Draghi announced that the ECB would start charging a negative interest rate on money banks deposit at the central bank, effectively making the banks pay the ECB to hold their money there rather than the banks earning interest on their deposits. (We’ve discussed this tactic — known as Interest on Excess Reserves or IOER — often on Making Sen$e with regard to the Fed, most recently late last year.)
What’s the point of a negative interest rate? The goal is to discourage banks from hoarding money at the ECB, and instead send it flowing back out to the borrowers and businesses that will stimulate the economy and raise inflation. When the euro is worth less, euro zone exports should become cheaper and consequently, more globally competitive. (The Upshot’s Neil Irwin offers a crisp explainer of the negative interest rate.)
In the euro zone, maintaining 2 percent inflation is the central bank’s only mandate, and toying with interest rates is their main stimulatory tool. The Federal Reserve, by contrast, has what’s commonly referred to as a dual mandate: managing inflation while striving for “full” employment.
In the United States, the decline of the unemployment rate over the past year has led the Fed to gradually draw down its hallmark monetary stimulus program. The Fed has said it will continue gradually reducing the purchase of mortgage-backed securities and U.S. Treasuries — the program known as quantitative easing — with a total drawdown this fall, as long as the economy meets their expectations.
The Fed’s super-national counterpart in the euro zone isn’t making those kinds of asset purchases, in large part, former Fed economist Catherine Mann reminds us, because it represents nation-states, not states, and to decide whose sovereign debt to buy would amount to playing political favorites. Draghi floated the idea of asset purchases in 2012, when he promised “to do whatever it takes to preserve the euro.” But he never actually had to do it; as the Wall Street Journal explains, the mere promise that he would do it if needed was enough for investors. Since Draghi never had to act, he never addressed how to handle the sovereignty question, says Mann, now a professor at Brandeis’ International Business School. On Thursday, Draghi again left the door open to buying assets in the future, but as Mann explains, this would be different from the Fed’s quantitative easing program because they’d be buying private asset-backed securities.
For now, the European Central Bank is still using its ability to set rates on money deposited at the Bank to try to keep inflation where they want it. But in a super-national organization, even determining the inflation rate is a challenge since Europe has a range of them. Rolling those into one clean number carries with it statistical and political complications. So even though the ECB has only one mandate, where the Fed has two, Mann explains, theirs is somewhat harder to achieve. But “however you cut it,” Mann continues, “they are a long way away from their objective.”
Which is why the ECB took the unprecedented step of lowering the deposit rate from zero to minus .1 percent for banks to park their money at the central bank overnight. Denmark experimented with a negative rate, but never before has a negative interest rate policy (“NIRP,” for the wonks used to talking about a zero interest rate policy or “ZIRP”) been implemented on this large a scale.
The question now is what will happen once the rates go into effect on June 11. A negative interest rate “sounds radical,” says Benn Steil, senior fellow and director of international economics at the Council on Foreign Relations. “And the optics are very dramatic,” he adds, but it’s “unlikely to have much more of a stimulative effect” than the already low rate.
Banks like to make themselves seem local, with branches rooting themselves in our neighborhoods. But it’s important to remember, Mann stresses, that banks are global, with no respect for international boundaries. So the effectiveness of any interest rate policy, she says, “will be tempered by the fact that money is fungible across borders and across the ECB.”
That’s not unique to the ECB, of course. As Mann explained to Making Sen$e late last year when the Federal Reserve was taking its initial steps to taper quantitative easing, the Fed’s lowered interest rates send capital abroad, especially to emerging economies, where it can get a higher return.
With NIRP, banks in Europe are likely going to want to send money abroad too. Naturally, they won’t want to deposit and hold their extra reserves at the European Central Bank if they have to pay to do so. Instead, they can funnel it to branches in the United States, where it can earn a quarter of a percentage point interest, aka 25 basis points, at the Federal Reserve.
This flow of capital, Mann thinks, represents a kind of leakage because the money that is diverted from one central bank and lands at another never reaches the economy it’s supposed to stimulate. Encouraging hiring and generating demand for goods and services is the whole point of freeing money from the central bank in the first place.
The constant challenge for both the ECB and the Fed, she says, has been how to push that credit into the economy to stimulate growth. Inducing even more of it to be deposited at the Fed, or at another bank in Europe, isn’t going to change anything.
So besides lowering that deposit rate, the ECB is deploying another tool to arrive at the same goal. To discourage banks from keeping their excess reserves on the central bank balance sheet, the ECB will reward banks that increase their private lending (to non-bank institutions) with access to cheap funds. That’s been tried before in England, but Benn Steil isn’t convinced of the results: the banks were rewarded for loans he thinks they would have made anyway.
Mann, too, is skeptical, given failed efforts in the United States to push banks to lend to the nonfinancial sector, although none of the Fed’s stimulus programs have been attached to explicit lending. In short, “it’s a great idea,” she thinks, but businesses can also use the money for stock buybacks or mergers and acquisitions. She likens the concept to a relay race: central banks pass the money on to businesses, which are supposed to pass the baton on in the form of hiring people and building products. But corporations often drop that last baton. And if they don’t think they have good investment opportunities, given slack consumer demand and/or more capacity than they need, who can blame them?
Again, as is the case when lowered deposit rates at the European Central Bank send excess reserves to other central banks, when funds sit at European corporations that don’t use them for hiring, it’s the economy that loses out.
But the scariest concern for most non-economists right now may be the sound of a negative interest rate. If negative interest rates cut into banks’ margins, surely they’ll try to pass those negative rates onto their customers. What can everyday Europeans with a modest bank account expect?
Neither Mann nor Steil thinks the banks would want to alienate their customer base. But while they may not pass those rates onto their customers, they may still pass on the cost and just call it something else, like a new fee structure, Mann speculates. Even if that comes to pass, Steil thinks most retail customers would be reluctant to move their money around from one bank to another. Even so, the fear that depositors will remove their money from the banking system entirely, Neil Irwin notes in The New York Times, will likely keep central banks from ever making rates highly negative.
At the end of the day, Steil thinks, the ECB’s announcement makes holding assets in the euro zone less attractive. But that could all change if, as Draghi suggested on Thursday, the ECB is seriously open to some sort of asset purchasing program like the Federal Reserve’s quantitative easing. (Although Draghi specifically talked about buying private sector asset-backed securities, whereas the Fed buys government debt.) “We think this is a significant package,” Draghi said at the ECB’s announcement of the rate cut and lending package Thursday. “Are we finished? The answer is no.”