The European Central Bank (ECB) made its latest monetary policy decision early this month facing ongoing concerns about sluggish economic growth. Stating that the Eurozone had fared well in the face of financial fallout from the recent Brexit vote, the bank opted to maintain its benchmark rate at zero and its deposit rate at negative 0.4 percent, as it has been since March 2016. Though the bank continues to stand by its use of quantitative easing and unconventional negative rates, many economists are starting to doubt whether or not these methods are still effective.
In charge of setting the monetary policy of the nineteen euro countries, the ECB was the first major central bank to set negative rates when it lowered its deposit rate below zero in June 2014. Since then, other major central banks including Denmark, Switzerland, Sweden, and Japan have followed suit. A method that would have been unthinkable back before the global financial crisis in 2008, the idea of negative rates is to reinvigorate the economy by encouraging lending and spurring inflation. By essentially charging banks to deposit their reserves at the ECB, the hope is that banks will have an incentive to make more loans and lower retail interest rates. Lowered interest rates means that cost of borrowing is reduced, and thus individuals may be more likely to increase investment and consumption.
While the ECB claims retail banking deposits have continued growing at a similar rate as they were prior to the introduction of negative interest rates, it is clear that the unorthodox strategy has not had an exceptional impact thus far. Inflation in the euro-area has been hovering around 0.2 percent, which falls short of the two percent target value. The worry now is that future growth in lending may not be enough to offset the declining bank profitability caused by holding rates so low for so long. Banks are no longer facing a systemic balance sheet crisis like they were in 2012. If rates are pushed too low, experts worry that banks and individuals desperate for higher returns may start to take foolish risks or make large investments overseas, driving up prices and creating dangerous bubbles. There is also a risk that banks will raise retail account fees to cover the rising costs of depositing central bank reserves, thus discouraging individuals from storing their money with banks and causing further instability.
In fact, though it is generally considered taboo for banks to pass the negative rates onto their customers for fear of losing business, a German cooperative savings bank announced that effective from September onwards, it would charge a rate of negative 0.4 percent—a direct transfer of the ECB deposit rate—for all savings over 100,000 euros. The bank, Raiffeisen Gmund am Tegernsee, is a small one and estimated that the new rate would only affect 140 customers. Michael Kemmer, head of the Association of German Banks said he does not expect many other banks to follow in suit of Raiffeisen Gmund am Tegernsee because competition between banks in Germany is much too strong. However, this is still the opposite effect of what negative rates were intended to achieve. Instead of being encouraged to spend and invest in the still sluggish economy, wealthy individuals at this bank are now essentially being taxed.
Part of the reason that negative rates have had such an underwhelming impact is that the underlying issues of weak investment and consumer demand have not been directly addressed. Across the Eurozone, unemployment is above ten percent and household spending is restricted. If demand for goods does not increase, businesses are unlikely to borrow money for investment regardless of how cheap it may be to do so. Thus, the ECB’s unorthodox negative rates alone have limited efficacy. For this reason, many economists think the ECB needs to rely more on its asset-purchase program than on further reduction of interest rates to boost inflation.
Currently, the ECB has a 1.7 trillion euro quantitative easing plan, set to run through March 2017, where it makes debt purchases of 80 billion euros each month. Several economists surveyed by Bloomberg even believe that the plan will be extend six months, provided the ECB does not run into a scarcity of bonds. The restriction here, is that there is a maximum proportion of any single public security, called the issue limit, that the ECB can hold in order to prevent them from becoming a dominant investor and having the power to block restructuring. While the issue limit is adjustable, doing so can distort markets and can debatably be viewed as financing government deficits—an action that is illegal under EU law. Additionally, the ECB has a self-imposed rule that debt is eligible for purchase only if it has a higher yield than the central bank deposit rate, which prevents it from purchasing more from highly indebted nations such as Italy.
Although Mario Draghi, the central bank’s president, has made it clear that the bank will consider whatever measures necessary to see a sustained adjustment in the path of inflation, he has recommended that governments increase spending and implement structural reforms to lead to more sustainable economic growth and develop higher resilience to global shocks. This would be a deviation from the general consensus held by the bloc of euro countries, which has been to push for balanced budgets. Still, anything is possible – the next monetary policy meeting of the ECB governing council will be held on October 20th.
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