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.

the end game for the Eurozone

the ECB plan

After consultation with the the heads of Eurozone governments, the ECB yesterday announced its latest efforts to stem the Eurozone financial crisis.  The central bank will buy one- to three-year government debt of Eurozone members like Spain and Italy, which have been unable to borrow at reasonable rates of interest in the public markets.

There’s no cap on the amount the ECB will buy.  The action is subject only to the requirement that the countries in question abide by policy (read: austerity) rules agreed to with the ECB and the IMF.

The plan has been an open secret in securities markets for the past month or so, with European stocks and 10-year Spanish/Italian bonds rallying by over 10% during that time.  In contrast,to my mind the first really substantial positive reaction in US stocks came in post-announcement trading yesterday.


The bond buying will be “sterilized”–that is, it will be offset by equivalent buying elsewhere along the yield curve.  The intention is not to increase the overall money supply, thereby creating possible future inflation.

This is an important procedural point, given the continental European (read:  German) obsessive fear of any rise in the price level.  However, given the crushing burden of high real interest rates in the weaker parts of the Eurozone, a little inflation is the last thing the ECB has to worry about.

Although I haven’t seen details, other than that the purchases will be in money market securities, presumably the offsetting buys will be in German and French debt, which are trading at negative interest rates at present.

where to from here?

The most important aspect of the ECB move is that it sets a direction–and a precedent–that can be quietly modified as time goes on.  Yes, the current program is limited to at most three-year maturities.   But maybe that limit will gradually be relaxed.  Yes, the current intervention is being totally sterilized.  But maybe that will change, as well.

The key to the ECB plan working is the continuing good faith implementation by the weaker Eurozone nations of the fiscal policy reforms they’ve already agreed to.  My guess is that this will prove not to be a problem in the case of either Spain or Italy.


Greece is another question, though.  Objectively speaking, Greece–and Greek sovereign debt–are small enough in the overall Eurozone context that they don’t matter that much. But the country’s continuing refusal to implement already agreed to fiscal belt-tightening measures, and its incessant haggling for better aid terms from the EU/IMF, make it a thorn in the side of the Eurozone.  My guess is that there’s already a plan in place to force Greece out of both the Eurozone and the EU.  Bad for Greece–and for any publicly traded companies holding Greek assets. But it might be necessary to keep, say, Italy from backsliding.

The details of a possible ouster would doubtless also be messy, since integration of Greece into the wider EU has been going on for over a decade.  And the move might roil securities markets for a short while.  Still, my guess, however, is that most investors would greet the move with a sigh of relief, not with increased angst that the EU itself is unraveling.

what to fret over about now

If we strike the imminent collapse of the Eurozone off our list of worries, what’s left?

The upcoming US election, as a proxy for long-term growth prospects for the United States, is probably, by default, at the top.