June this year will mark the fifth anniversary of the ECB’s decision to cut its Deposit rate into negative territory, with three subsequent moves taking it to the curent -0.4%. That, alongside excess liquidity of some €1,800bn, means that it is the deposit rate and not the zero refinancing rate which drives short term money market rates, and these have also been negative for years now.
Three other European Central Banks have negative policy rates -Denmark, Sweden and Switzerland- as well as the Bank of Japan , while both the Federal Reserve and the Bank of England chose to cut rates to very low but nonetheless positive levels.
In theory, low interest rates are expected to boost economic activity and inflation by encouraging households to borrow and spend instead of saving, and to boost capital investment by the business sector. Low rates relative to other economies may also lead to a currency depreciation, which , again in theory, is thought to boost exports and hence economic growth. Negative rates are therefore merely an extension of lower rates, it is argued. Such rates in the EA have certainly helped to lower the cost of funds for the banking sector, as often pointed out by the ECB, but one would have to conclude that the net effect has been disappointing; monetary growth has been limp, the growth in bank lending to the private sector has been modest ( annual growth slowed to 3% in January) and core inflation has remained stubbornly anchored around 1%.
It is also apparent that negative rates have had negative consequences. It has been evident for some time from the ECB’s Bank Lending surveys that most banks report pressure on net interest margins, given that rates payable by borrowers have fallen, as has the yield on bonds held by banks (many of which are also negative), but that zero is the effective lower bound for rates payable to retail depositors. Higher loan volumes might offer an offset but, as noted, credit growth across the zone has been tepid and very weak in some countries (Irish mortgage growth only turned positive in 2018 ). The knock-on effect is that European banks are generally trading well below book value , in contrast to their US peers, which may not be a concern to many but is of concern to the ECB as it fears the consequences for future credit growth.
Negative rates are also a crisis measure, by definition, and that signal is probably encouraging households to save more rather than less, despite or even because of the meagre returns, Similarly, it is the prospect of return rather than the cost of borrowing which drives business investment, so negative rates may well dampen the former because the of the message on the economic outlook they send.
When will rates turn positive? Last year the ECB grew increasingly confident that underlying inflation in the EA was picking up, helped by stronger wage growth, and duly signalled that the first upward move in rates would occur from around September 2019. That forward guidance remains in place but the market is now only fully priced for a 10bp increase in the Deposit rate in the summer of 2020, given the recent weak data and the lack of any upward move in core inflation. The rhetoric from the ECB’s Governing Council has now changed and it would not be a surprise if the forward guidance was tweaked at the upcoming policy meeting.
Market expectations change, of course, moving with the flow of data, but for the moment 3-month rates are not expected to turn positive until the summer of 2021. The ECB may therefore be stuck in a rate trap, in that rates will only turn positive in response to a material pick up in core inflation, but that outcome is rendered less likely by negative rates.