Euro-Area Interest Rates: To Zero and Beyond?
There has been some speculation that the European Central Bank (ECB) may soon push its deposit rate into negative territory.
We think a cut in the deposit rate would be a poor substitute for measures aimed directly at repairing the monetary transmission mechanism in the troubled peripheral countries. But there’s a case for reducing the deposit rate, and one which we think is worth rehearsing.
From an economic perspective, there are two main arguments for pushing interest rates into negative territory. First, it is the only way to ensure that an economy continues to benefit from negative real rates when it enters deflation. But this is not a factor in the euro area today. With inflation at 2.7% and the overnight rate at 0.1%, real interest rates are still heavily negative. This is in marked contrast with Japan, where persistent deflation has kept real interest rates positive for much of the last decade.
Second, by placing a “tax” on excess reserves, a negative deposit rate should encourage banks to put this money to work. Ideally, this would take the form of increased lending to households and firms. However, purchases of higher-yielding assets such as government bonds would also help, by pushing yields lower and reducing financing costs for the whole economy. At first glance, this argument has a certain appeal. Because of the huge amounts of funds being borrowed from the ECB by banks in the periphery, the amount of excess reserves in the euro-area banking system currently stands at over €700 billion.
But it is not clear that a deposit rate of –0.25% would encourage risk-averse banks to put excess reserves to work. The situation is complicated by the fact that most of the excess reserves in the euro area are held by banks in core countries, where credit availability is ample and monetary conditions may already be too loose. The main effect of a negative deposit rate might therefore be to unbalance the ECB’s monetary policy further, and put downward pressure on bond yields in the core countries (as banks shift into higher-yielding domestic assets).
The case for a negative deposit rate would be stronger if it encouraged a resumption of cross- border flows back into the periphery—either directly via the banking system or indirectly as lower yields in the core countries force investors to look abroad for higher-yielding assets. Unfortunately, we are skeptical that this would work. In any case, a reduction in the deposit rate is likely to be far less effective in achieving this goal than using targeted nonstandard measures, such as the ECB’s new bond-purchase program.
This brings us to the key point. The chief problem in the euro area at present is not the level of policy interest rates or even the amount of liquidity in the banking system. Rather, it is the transmission of monetary policy to all parts of the region. This, in our view, is where the ECB will continue to concentrate its efforts. Of course, economic conditions in the euro area (as a whole) might deteriorate to such an extent that the ECB is left with few options but to push rates into negative territory. But that is unlikely to come any time soon.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.