ECB and Negative Interest Rates

June 9, 2014
With the historic action by the European Central Bank, here is an explanation of what the ECB’s action means in regards to negative interest rates.

The European Central Bank (ECB) introduced negative interest rates for the first time in its history.  This historic action caught the attention of the press, so I thought you might like a quick look at what it means without having to listen to a long lecture that will make the details on the back of your library card look interesting. The goal of all of this is to spur economic activity and thus end the deflationary threat by introducing inflationary pressures.  The other goal is to stop the strengthening of the Euro as a weaker Euro will make selling more exports easier and also make imports more expensive, and even slightly more expensive imports means some inflationary pressures. 

The ECB cut its deposit rate to -0.1%.  In a perhaps too-simple illustration, this would be similar to your bank charging you money to leave your money on deposit and you cannot go to another bank for a better deal.  You would have a greater incentive to go out and put that money to work for you rather than having it actually cost you something to do nothing by just letting the money sit in the bank.

The central bank is also planning on encouraging lending to smaller companies who have not had much access to capital.  Cash starved firms who are looking at growth or efficiency opportunities may take advantage of the situation and borrow/spend and thus spur some economic activity and eventually job growth. 

ECB President Draghi also said they are preparing an asset purchase program.  Think Quantitative Easing.  The goal is to pump money into the banks and thus make it easier for the banks to lend and make the cash available to businesses. They will have the same problem that the US had.  Businesses with good balance sheets can borrow, but will they actually do so to spend money on capital assets or will they use the money to deleverage at today’s cheaper rates?  The latter does not help fight deflation because it does not have much of a fast, near-term punch in terms of economic growth. 

How this will impact the value of the Euro is a tougher question.  It worked in Denmark because it stemmed the flow of funds into the country, but that does not mean it will work for the Euro.  The fact that there is an announced stimulus package may make investors more bullish on Europe in terms of safety, and thus it could drive up the Euro in relation to the US Dollar.  I would not look for significant changes either way with the greater likelihood of a slight weakening in the Euro.  Please remember that global currency markets are complicated and not driven by pure logic or just the numbers.  Reading between the lines, anticipation, and trust in the central bank’s abilities are all additional factors.  Be careful, nothing is a ‘given’ now in regards to the Euro.

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