Draghi May Enter Twilight Zone Where Fed Fears to Tread
While cutting ECB rates may boost confidence, stimulate lending and foster growth, it could also involve reducing the bank’s deposit rate to zero or even lower. Once an obstacle for policy makers because it risks hurting the money markets they’re trying to revive, cutting the deposit rate from 0.25 percent is no longer a taboo, two euro-area central bank officials said on June 15.
“The European recession is worsening, the ECB has to do more,” said Julian Callow, chief European economist at Barclays Capital in London, who forecasts rates will be cut at the ECB’s next policy meeting on July 5. “A negative deposit rate is something they need to consider but taking it to zero as a first step is more likely.”
Should Draghi elect to cut the deposit rate to zero or lower, he’ll be entering territory few policy makers have dared to venture. Sweden’s Riksbank in July 2009 became the world’s first central bank to charge financial institutions for the money they deposited with it overnight. The Fed rejected cutting its deposit rate from 0.25 percent last year. With Europe’s debt crisis damping inflation pressures and curbing growth, the ECB may feel the benefits outweigh the negatives.
“A rate cut could have an important psychological effect in the current environment,” said Christoph Kind, head of asset allocation at Frankfurt Trust, which manages about $20 billion. “Negative interest rates aren’t an irrational concept. I’m not sure, though, whether in the case of the ECB it will have the desired effect.”
The ECB uses three interest rates to steer borrowing costs in financial markets. The main refinancing rate determines how much banks pay for ECB loans, while the deposit and marginal rates provide a floor and ceiling for the interest banks charge each other overnight.
If the deposit rate was cut to zero or lower, it would discourage banks from parking excess liquidity with the ECB overnight, potentially prompting them to lend the cash instead. Almost 800 billion euros ($1 trillion) is being deposited with the ECB each day.
On the other hand, a deposit rate cut could hurt banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to other financial institutions.
“It won’t help the prospect of a functioning money market because banks won’t be compensated for the risk they’re taking,” said Orlando Green, a fixed-income strategist at Credit Agricole Corporate & Investment Bank in London. It would make more sense to lower the benchmark rate, thus reducing the interest banks pay on ECB loans, and keep the deposit rate where it is, Green said.
The ECB has lent banks more than 1 trillion euros in three- year loans, with the interest determined by the average of the benchmark rate over that period. Societe Generale SA estimates that cutting the key rate by 50 basis points would save banks 5 billion euros a year.
The deposit rate traditionally moves in tandem with the benchmark, which policy makers kept at a record low of 1 percent on June 6. Draghi said “a few” officials called for a cut, fueling speculation the bank could act next month.
The deposit rate has served as the de facto benchmark, steering overnight market borrowing costs, since the ECB started to provide banks with unlimited liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008. That policy removed the need for banks to borrow from each other to meet their reserve requirements, pushing down interest rates. The euro overnight index average, or Eonia, stood at 0.33 percent yesterday.
“If you want to ease monetary policy, you won’t get it from cutting the main refinancing rate,” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. “Reducing it alone wouldn’t translate into lower market rates. Slashing the deposit rate makes more sense.”
The ECB isn’t the only central bank in Europe considering cutting interest rates below zero. Denmark’s central bank signaled last month that it is willing to let rates go negative to fight an appreciation of the krone, and the Swiss government has said it’s also assessing emergency measures such as negative rates to weaken the franc if Europe’s debt crisis escalates.
Other institutions have opted against such a move. The Fed started paying interest on deposits to help keep the federal funds rate near its target in October 2008 and has reimbursed banks with 0.25 percent on required and excess reserve balances since December that year.
Some Fed policy makers last August argued that reducing the rate could be helpful in easing financial conditions. While they discussed doing so in September, many expressed concern that such a move “risked costly disruptions to money markets and to the intermediation of credit,” the Fed said in minutes published on Oct. 12.
The Bank of Japan (8301) introduced a Complementary Deposit Facility in October 2008 to provide financial institutions with liquidity and stabilize markets, and has kept the interest it pays for the funds at 0.1 percent since then. Governor Masaaki Shirakawa told reporters on May 23 there would be “large demerits” to reducing the deposit rate because it could lead to a decline in money-market trading.
While the Bank of England cut its deposit rate to zero in March 2009, financial institutions that have a reserve account at the central bank don’t have an incentive to use the facility as all reserves are remunerated at the benchmark rate of 0.5 percent.
“If the ECB cut the deposit rate, it would take an important profit opportunity away from banks,” said Tobias Blattner, an economist at Daiwa Capital Markets Europe in London. By doing so, the ECB would also be “encouraging banks to lend to the real economy” even though “there’s hardly any demand for credit,” he said. Blattner predicts the ECB will cut its benchmark and leave the deposit rate at 0.25 percent.
ECB Executive Board member Benoit Coeure said on Feb. 19 that market interest rates of zero or lower “can result in a credit contraction.”
That’s because banks, trying to preserve their deposit bases by paying customers a reasonable interest rate, may reduce lending to companies and households because the return is too low and invest in higher-yielding assets instead.
The ECB has been examining the possible impact on markets of a deposit rate cut, helping to ease policy makers’ concerns, according to a euro-area official who asked not to be named because the deliberations are not public.
Callow said lowering the deposit rate would encourage banks in fiscally-sound countries like Germany, which are flush with excess cash, to lend to troubled banks on the euro-area periphery, which are dependent on ECB funding.
That would have the twin benefits of reducing banks’ addiction to ECB funding and shrinking excess liquidity in the system.
“A deposit rate at zero will be of particular support to banks in southern Europe because it could help encourage some flow of credit,” said Callow. “A negative deposit rate can be damaging for money markets.”
Negative rates would destroy the business model for money- market funds, which would face the prospect of paying to invest, said Societe Generale economist Klaus Baader.
European money-market funds totaled 1.1 trillion euros at the end of March, according data from Fitch Ratings Co.
“But the ECB doesn’t set policy to keep alive certain parts of the financial sector,” he said. “Policy makers want to show that they haven’t exhausted their options yet.”
Another consequence of an ECB deposit rate cut may be that some banks take advantage of a clause in the three-year loans allowing them to pay the money back after a year, which would reduce excess liquidity in the system.
That could be the basis for a compromise between the ECB and the Bundesbank, whose President Jens Weidmann has repeatedly warned of the risks related to too-generous liquidity provision, said Carsten Brzeski, senior economist at ING Group in Brussels.
“Reducing excess liquidity with a rate cut should sound rather interesting for the Bundesbank,” he said. “Maybe that’s the twilight zone where Draghi and Weidmann will meet.”
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