Wednesday, 10 July 2013

In the news: Negative interest rates

Many people, myself included, are getting a little exasperated at the European Central Bank’s (ECB) refusal to do more to support economic recovery in the eurozone. In particular, the ECB has repeatedly eschewed quantitative easing (QE), even though the UK, US and Japan have all tried it and shown that it can work well.

Interestingly, the IMF concluded its Article IV consultation with the eurozone (essentially a financial health check) on Monday, and while the Fund did call on the ECB to do more, it nudged the central bank not towards QE but towards a negative interest rate on deposits. The ECB has hinted in the past that it might be open to such a possibility.

IMF boss, Christine Lagarde (Photo credit:
World Economic Forum)
Negative interest rates are strange things, and for a long time people assumed they couldn’t possibly work. To have an interest rate below zero means that if I deposit money in the bank I would have to pay for the privilege, while the bank would have to pay me if I wanted to take out a loan. Sounds crazy, and for profit-making institutions, it is.

Central banks, however, can and do break the rules. Sweden dabbled in negative deposit rates back in 2009, and the Danish central bank currently has an interest rate of -0.1% on deposits. No one has yet tried a negative lending rate.

The thinking, as with all interest rate cuts, is that by making it costlier for banks to deposit cash, they are less likely to do so and instead will put it to productive uses such as lending it out.

However, as banks are unlikely to want to pass on negative rates to their depositors, they may have to take the hit themselves. A team of JP Morgan researchers underline this problem, pointing out that banks have to deposit excess reserves at the central bank at the end of the day, thereby earning a zero or negative return. There’s a lot of money sloshing around the eurozone at the moment (even if it’s not going to the places it’s needed most), creating a ‘hot potato’ effect where banks try not to be the ones holding it at the end of the day.

This means that a negative interest rate could just become a tax on banks.

The only way for banks to avoid this is to get rid of the reserves, for instance by paying back loans from the ECB, which banks in safer countries are trying to do. However, banks in crisis-hit countries still need the extra cash, and until they pay it back, all eurozone banks will suffer from the hot potato effect.

Amusingly, this unintended consequence may have a (positive) unintended consequence of its own. Banks passing the hot potato around increase the velocity of reserves and could end up sending money to where it’s needed most: e.g. the south.

Nevertheless, given how complicated negative interest rates are, I can’t help wondering why the ECB doesn’t just try some QE. Well, actually I know why: Germans.

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