Monday, 3 March 2014

Another New Policy - Negative Interest Rates

Another unconventional policy measure may be trialled in Europe as its central bank struggles to revive the moribund economy

The on-going economic troubles have been demanding in many ways – including having to learn the meanings of an ever-increasing range of new economic terms.  This is due to central banks implementing a range of practices to breathe life into an economy which seems impervious to their best efforts at resuscitation.  The list of unconventional policies started with quantitative easing, which was soon followed with forward guidance.  The next piece of headline-grabbing jargon may be negative interest rates.  This latest innovation is expected to come from the European Central Bank (ECB) even as other central banks look to wind down their operations.

The What, How, and Why of Negative Interest Rates

The policy of negative interest rates is just as simple as it sounds – paying someone to hold money instead of receiving interest on any deposits of cash.  Fortunately, the humble blogger on the street will not be required to pay negative interest rates by his or her retail bank; instead, the banks themselves will be charged for their holdings at the central bank.  Banks tend to park any surplus funds with the central bank so the idea of negative interest rates is to spur banks into making better use of their reserves.  In particular, the policy is intended to boost lending by banks which has remained sluggish despite record low interest rates.

The policy is all about creating the right incentives.  The actual payments themselves would be small.  For example, the ECB is said to be considering an interest rate of -0.1% in place of its current rate of 0.25%.  Central banks have been frustrated by the failure of low interest rates to generate the desired result – more lending.  Both forward guidance and negative interest rates are policies aimed at achieving this.  

Timing – why now?

Now we understand the basics of negative interest rates, the final question is one of timing – why now?  The ECB is driven by two key factors – the changes to monetary policy in the US and fears about deflation in Europe.

The effects of the Federal Reserve printing money to buy bonds (known as quantitative easing) have reached far beyond the US borders with some of the money also finding its way to Europe.  Less loot leaving the US will likely lead to less liquidity in the European banking system.  Low levels of inflation (0.7% in January) have led to fears about consumer prices starting to fall, something already happening in places like Greece.  There are concerns that such deflation could further undermine demand and result in debts increasing in size relative to the economy.

The potential adverse consequences of these developments have pushed the ECB to act and negative interest rates are one of the few options available.  This is because the actions of the ECB are restrained by divergent views among the member countries of the European Union.  In particular, Germany has been adamant in upholding rules that limit the ability of the ECB to purchase bonds. 

Negative interest rates would also bring their own complications.  European banks may struggle to deal with negative interest rates which are not the norm.  The extra costs may weaken banks by lowering their profits, making them more cautious lenders and exacerbating the problem.  Low lending rates have had only a muted effect so the benefits of going negative may be limited.  Even if the policy is seen to be effective, Germany would be loath to offer more help to struggling countries in the periphery of Europe as it may encourage them to put off crucial reforms.

It is too early to say whether negative interest rates will ever make it into our everyday lingo.  Either way, we can only hope that it does not take many more new policies until we can shake off the current economic stupor.

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