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3 June 2013 By Neil Unmack

Negative rates are the talk of the town in European monetary policy. European Central Bank officials can’t stop dangling them in front of markets, both talking up their readiness to use them whilst simultaneously fretting over the risks. This radical monetary policy might pull the fragmented euro zone back together. It could also backfire. The Breakingviews guide to negative rates explains why policymakers are being coy.

What are negative rates?

It sounds weird to pay someone to take money, but banks and investors can’t just hold their funds under a mattress. They have to put it somewhere: investors can make deposits in banks or buy short-term paper and banks can lend to other banks, or deposit their excess funds with their central bank.

The concept is clear, but isn’t it hypothetical?

Not at all. Investors have been happy to pay stronger countries to hold their funds for some time – when they worried about the euro zone breaking up, or were desperate for safe assets. German one-year bond yields, for example, turned negative in late 2011, and have drifted below zero several times since then. Last year the Danish central bank adopted negative rates as formal monetary policy, cutting its certificate of deposit rate to -0.2 percent in a bid to control its currency.

So why are we talking about them now?

The recent talk refers to the European Central Bank deposit rate. This rate currently sets the floor for money market rates in the euro zone. The ECB cut that to zero in July last year, but that doesn’t seem to be low enough to encourage banks to take the money and lend. The euro area economy is flat-lining, and inflation has fallen sharply recently. So people connected with the ECB have started to talk about negative rates.

Why is there no similar talk in the United States or other countries?

When the policy interest rate is effectively zero, most central banks can loosen monetary policy further by quantitative easing (QE) – using newly created money to buy government debt. The new funds are supposed to find their way into the economy, spurring economic activity. But those central banks have only one government, while the ECB has many – and it’s not supposed to favour one over another. Moreover, its largest shareholder, Germany, has an aversion to printing money. In theory, a negative deposit rate would have a similar effect to QE, encouraging banks and investors to take more risk in the search for higher returns, or any at all.

What’s the plan?

With any luck, a sharp cut – probably at least 50 basis points – might encourage the strong banks that are keeping cash at the central bank – currently roughly 250 billion euros of excess reserves – to lend rather than lose money on deposit. Indirectly, it would bring down other interest rates and government bond yields, and the easier credit conditions might encourage borrowing.

The ECB may be particularly hoping to make low-risk assets so unattractive that strong institutions can be persuaded to start lending again to weaker banks in the euro zone periphery, which currently depend instead on cheap funds from the ECB. Negative rates might combat this so-called fragmentation.

There should also be an impact on the currency. By making euro assets relatively unattractive, the ECB might devalue the euro, helping exporters.

Will it work?

No one knows, because negative rates have never been used as a policy tool in such a major economy, and the euro zone’s situation is unique. But QE has not been a clear success, apparently because lenders and borrowers remain hyper-cautious. Negative rates may well be unable to overcome this obstacle.

Could negative rates be worse than useless?

There are several potential technical problems. Computer systems of banks and traders might have a hard time coping with negative rates. Money market funds would struggle to earn their crust. But these issues are probably manageable.

More fundamentally, there may be some banks which are currently borrowing more than they need from the ECB and then depositing the excess with the central bank. If they simply repay their loans, as they have already started doing in recent months, rates might paradoxically rise in the money markets.

Another unintended consequence could follow if stronger banks aren’t persuaded to reduce deposits much at the ECB. They might counter their losses at the central bank by charging higher rates on loans. That would actually discourage borrowing.

It’s a paradox. Rates would have to be pretty steeply negative to have much effect, but the deeper the cut the greater the chance something will go seriously wrong.

Will the ECB do it?

Recent comments suggest that ECB policymakers are genuinely unsure. But if they were to go down the path of negative rates, they would want to give markets time to prepare. The signals so far are too mixed for preparations to start, so no move is imminent.

Should the ECB do it?

Considering the risks, the ECB would be wise to try less radical tools before going for the negative option. For example, it could loosen collateral rules for long-term liquidity operations or give banks really cheap, very long-dated loans at a fixed rate. It could also use its moral authority to push governments to make serious progress with the proposed banking union, or to set up funds to help small companies.

It sounds like all the talk is a waste of time

Not necessarily. The recent rash of comments tests the market reaction and helps get investors and banks used to the concept. The ECB could also be signalling that it still has room to manoeuvre to keep rates low for longer. In any case, the public debate on a negative rate has pushed the market to price in some probability of it happening – another example of the central bank’s ability to make markets do the heavy lifting.


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