The next ECB policy meeting is scheduled for March 10th, and the market is expecting further monetary easing. This was flagged in January , when it was announced that the Governing Council would ‘review and possibly reconsider the policy stance‘ given that downside risks had risen. The minutes show that some Council members favoured immediate action but the consensus was to await the publication of the quarterly macroeconomic forecasts, incorporating projections out to 2018. The current forecasts envisage inflation rising from 1.0% this year to 1.6% next, but are predicated on an oil price of $52 a barrel in 2016, which looks untenable in the absence of a seismic shift in global oil supply. Headline inflation had turned positive again in late 2015 and rose to 0.3% in January but the flash reading for February was surprisingly weak, at -0.2%, with core inflation also slowing to 0.7%.
Euro bond yields have fallen and the euro has depreciated of late in anticipation of ECB action, but the Bank has been cautious in terms of inflating expectations, mindful of the market reaction to its December announcements, which were deemed disappointing relative to what Mario Draghi was interpreted as signaling. The euro’s effective exchange rate subsequently appreciated , rising by 6% to mid-February, and speculative short positions in the euro/ dollar fell sharply. Of course there were other factors at work, including changing expectations about US monetary policy, but it is noteworthy that the ECB minutes warned against raising ‘undue or excessive expectations about policy action’ given what had happened in December.
What can the ECB do?. One option is to reduce the Deposit rate further into negative territory, as other central banks have done, The rate, currently -0.3%, is paid on overnight deposits at the ECB and the idea is that banks will be encouraged to lend to other banks or to use these reserves to support lending to the private sector, rather than face losses by continuing to park it with the ECB. A cut in the deposit rate, it is also argued, will put further downward pressure on money market rates and bond yields, so precipitating a fall in the currency, which would in turn help to boost inflation.
Yet rates paid by banks to depositors are unlikely to turn negative and many loans are based on money market rates, such as 3 or 6- month euribor. Consequently negative rates hit bank margins and hence profitability. Some argue , including ECB Board Members, that this can be offset by strong lending growth but that is certainly not happening in the euro area, with the annual growth in loans to the private sector at just 0.6% in January . Consumers and firms in many countries are still reducing their debt levels (including Ireland, where net credit has been contracting now for 6 years) and on the supply side banks are building capital to meet changed regulatory requirements and are saddled with high levels of non-performing loans. Moreover, lending to consumers or businesses is risky and requires higher capital cover than lending to governments , where zero capital is required, particularly when the ECB is in the market buying government debt. The general public may feel that bank profitability is the least of their concerns but a healthier bank system is required if the euro area is to see stronger economic growth and negative rates will not help.
Moreover, negative rates send the signal that economic conditions are far from normal and may exacerbate the perception that monetary policy has indeed reached its limits, and may now be adding to problems rather than easing them. It is also not a given that a further rate cut by the ECB will lead to a sharp depreciation in the euro- witness the recent rally in the Yen following the bank of Japan’s move into negative rate territory- and the euro area’s huge current account surplus means capital outflows have to be enormous to push the currency lower on a sustained basis.
Conceptually, negative deposit rates, if expected to last a long time, could also lead to a fundamental change in the financial system. Rates on cash are not negative ( excluding some storage costs ) so banks may decide to hold excess reserves in cash rather than deposit them with the central bank. Similarly, retail depositors would have an incentive to do the same thing if commercial banks sought to introduce negative deposit rates on a large scale, so threatening the main function of the banking system, the intermediation of savers and borrowers.
In sum, negative rates are not the answer and symptomatic of a refusal by central banks to accept that the emperor no longer has any clothes. Time for Governments to take advantage of historically low or even negative bond yields and fund some sensible capital spending , which would boost demand in the short term and support higher growth further out.