the European Central Bank (ECB) is now charging for overnight money storage

Yesterday, the ECB reduced interest rates across the board in he EU and pledged to provide extra financing at cheap rates for four years to banks that lend to consumers and businesses.  The real eyecatcher, however, was the central bank’s decision to reduce the rate it pays member banks on overnight deposits to -.10%.

What’s this all about?

The standard way for governments to fight economic slowdowns in the post-WWII world is to reduce interest rates until they’re substantially below the rate of inflation–and keep them there until recovery begins.  If the interest on a loan is, say, 3% and prices/salaries are rising at a 5% annual clip, the borrower is getting a 2% subsidy from the government just to take the funds and invest them.

The process is well understood and virtually always employed.

Two things are unusual about the current situation in the US and the EU.  One is that we’ve had negative real interest rates for such a long time.  In the US, for example, we’ve had negative real interest rates for over five years.  In a garden variety recession, rates might be negative for five months.

The second is what economists call the “zero bound” issue.  Conventional wisdom says that governments can’t/shouldn’t reduce nominal interest rates below zero.  This is partly because it sounds weird and the issue has seldom come up.  Mostly, though, it’s because the world has no experience with negative nominal interest rates.  The fear is that there will be unintended negative consequences of having the central bank set rates below zero.

On the other hand, there’s the quarter-century of economic stagnation in Japan to consider, where rates stayed above zero while the economy contracted slightly year after year.  Real interest rates remained strongly positive, as a result, depressing any sparks of economic progress–year after year.  Not a happy outcome.

In the case of the EU, overall prices are now rising at a mere +0.5%, with economist predicting that it is likely to contract further in coming months.  This is making Europe look increasingly like Japan circa 1990, when that country’s long-lasting malaise began.

So, the ECB has apparently concluded that negative rates don’t look so bad.

Market reaction so far seems to be that while the move has a certain shock value, rates are unlikely to move lower.  Quantitative easing, of the type now being “tapered” in the US is the likely next step.  But if so, why break the zero bound in the first place?  Maybe some idle cash now parked in euros will move elsewhere, thereby weakening the currency.  More likely, to me at least, is that someone on the ECB board needs to be convinced that all other avenues have been explored before commencing with QE.

If that’s correct, negative interest rates will remain a curiosity.  My guess is that any substantial economic impact will only come if the ECB lowers rates further into negative territory.

It’s certainly worth thinking about what might happen if the bank does so.

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