Responding to press conference questions, ECB President Mario Draghi has said the ECB is ‘technically ready’ to bring interest rates below zero.
Yesterday, Bloomberg reported rumors that the ECB is ready to act. Today, Draghi denied that there is anything new happening on this front, and ECB Board member Asmussen said he’d be cautious about using negative rates.
While traders keep trying to guess Draghi’s next move, one may want to consider, one more time, the effects of negative interest rates.
Some background information on banks’ deposits at the ECB and interest
Eurozone banks keep their euros in Reserve Accounts at the ECB. Currently, banks have a total of 268 billion (October 2013 data) in these accounts. Euros keep moving between banks, since nearly every single payment that banks make on behalf of their clients is settled through these accounts.
A share of these funds is considered ‘required’: This is the minimum balance, set by the ECB, equivalent to one percent of the deposits that clients hold at Eurozone banks. The required share is now 103 billion and the ECB paid 0.50% interest on the required amount in October. In November, it will pay 0,25%. No interest is paid on funds in excess of the required amount. (Data source: ECB)
In addition, Eurozone banks can move their excess funds into another account, called Deposit Facility. The ECB normally pays interest on the entire balance of this account. Today, however, remuneration is zero. Banks have 59 billion in such accounts where they earn no interest.
Negative interest rates: How would they work?
The ECB has yet to announce how it would implement a negative rate policy, so one can only guess.
One possibility is that it will lower the rate on the Deposit Facility to below zero. Negative interest on the Deposit Facility means that any bank holding funds in this type of account would pay (not earn) interest. Because banks can always move their funds out of the Deposit Facility into their Reserve Account they would easily avoid paying this ‘tax’.
Thus, to make the move somehow effective, the ECB would have to lower below zero the remuneration on any excess reserves, including any excess funds held on the Reserve Account. This way, banks would have no place to go: If they move their funds out of the Deposit Facility into the Reserve Account, they would still pay the ‘tax’, graciously called a ‘negative interest rate’.
Negative interest rates: What for?
Suppose Eurozone banks were being taxed on their excess reserves. What would be the effects?
– Banks’ profits fall and their net worth drops. This is how taxes work. A lower net worth will lower the incentive for lending.
– Banks will have an incentive to pay interest to another bank if that bank is willing to hold their reserves: If Bank A must pay Bank B, Bank A may keep its reserves and be paid by Bank B for holding them. The interbank market rate, in other words, falls below zero, its new floor being the official ECB negative rate.
– Banks are in no position to unilaterally eliminate excess reserves, so they will continue paying the tax as long as they have excess reserves. Even if they increased lending (with falling net worth!), they would be unable to get rid of excess reserves: They could only pass on the ‘hot potato’ from one to the other. Overall excess reserves shrink only when the ECB carries out ‘liquidity absorption operations’, not when banks make loans.
– The price of euros in terms of dollars may decline some, and this may encourage exports on the condition that foreign aggregate demand (ultimately funded by foreign government deficits) remains strong enough. However, if budget deficits remain small for austerity, and if prices rise less than 2%, the euro will soon find a resistance level.
– At the macro level, the tax is another leakage of financial assets for the private sector: With less euros in the private sector, the price of the euro in terms of dollars may actually rise, countering any depreciation effect.
Conclusion: A negative interest rate is just another tax.