The Independent Market Observer

Use It or Lose It, Banks: ECB Introduces Negative Interest Rate

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 5, 2014 3:13:00 PM Leave a comment

negative interest rateThe European crisis isn’t over. This is according to a very authoritative source—the European Central Bank, which just took the almost unprecedented step of instituting a negative interest rate, essentially charging banks to deposit money. For the banks, it really has become a case of using their deposits or slowly losing them.

What’s driving the ECB's move?

In a word, desperation. European growth has been lackluster for years, and it has shown little sign of improving in many countries. Unemployment is at depression levels in a number of places: 25.6 percent in Spain, 27.5 percent in Greece, 15.3 percent in Portugal, 12.7 percent in Italy, and 12 percent in Ireland. Unemployment in the eurozone as a whole is 11.9 percent, virtually unchanged over the past year. (Compare that with 6.7 percent in the U.S., down a full percentage point over the past year.) Youth unemployment is even worse, at 23.5 percent in the eurozone—again, almost unchanged from the prior year.

The unemployment crisis continues, with no real improvement, despite the very slow recovery of the eurozone economies. This is a chicken and egg problem. With consumer demand representing the largest part of the economy, a lack of employment and wage income slows spending and the recovery, which in turn makes companies reluctant to hire, prolonging the problem.

Will it work?

The Federal Reserve instituted its quantitative easing bond-buying program specifically to inject money back into the system and kick-start growth. For all the criticism leveled against it, it worked. We do have a problem with banks not lending, but that has started to change. For many reasons, banks in Europe have been unwilling to lend, and the European Central Bank has been unable to execute the same kind of bond-buying program, leaving the problem to fester.

Thus far, the ECB has relied on rate cuts, as the Fed did initially. It just cut the short-term interest rate by another 10 basis points, to a new low of 0.15 percent, but practically speaking, this makes no difference, as ECB President Mario Draghi acknowledged. Borrowers who won’t borrow at 0.25 percent are unlikely to change their minds at 0.15 percent. The ECB’s ability to encourage borrowers to pull on the funds is played out. With no influence on borrowers left, it moved to pushing the banks to lend.

The record on negative interest rates is limited, and mixed. Even with this charge, banks may well decide that the potential returns from lending are even worse—and continue sitting on funds. Worse, they may start discouraging deposits from businesses and regular people, further distorting the financial system. While the goal is to get money moving again, that is by no means assured.

What does this mean for the U.S.?

A few things:

  • First, it shows how much progress we’ve made that our programs are actually working, and how far ahead of Europe we are in the recovery.
  • Second, it should remind investors that the European crisis isn’t over.
  • Third, if all goes as planned, these and other policy actions will result in a weaker euro, which means the dollar should strengthen, eroding the competitive position of U.S. companies.

We really don’t know what will happen, though. The ECB has been forced to take another step into the unknown in an attempt to revive its economies, even as the U.S. recovery is under way. Let’s hope it succeeds, or we could see another wave of turbulence in the not-too-distant future. Fortunately, we’re much better positioned to weather it this time.

 

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