IBE MAGINE locked in a dark room. For fear of banging against a wall or tripping over, step forward with your arms outstretched. So is the European Central Bank (ECB) has approached rate cuts since it first ventured into sub-zero territory in 2014. It knows that there is a limit to how low interest rates can be and that the limit is near, but like the business profession in the broader sense, it has no idea when it will hit the wall. With subdued growth and inflation, it cautiously cut interest rates by 0.1 percentage points each. Even before covid-19 arrived, the deposit rate had dropped to -0.5%. Instead of lowering interest rates further, it has since relied on unconventional measures such as buying bonds. Much of its incentive came from expanding lending to banks and decoupling the system’s interest rate from key policy rates. With the introduction of double interest rates, the ECB could well escape its locked room.
Interest rate cuts are designed to encourage businesses and households to spend by making borrowing more attractive and saving less. However, when interest rates are negative, their transmission to the real economy collapses. Depositors can keep their money in cash at any time, which has an effective interest rate of zero. Banks fear that if customers pass on negative interest rates, they will pull out their money and tuck it under mattresses instead. The result is squashed net interest income for banks, a deterioration in their profitability, and possibly a reduced willingness to lend. Economists assume that from a certain point – the so-called reversal rate – the stimulating effect of an interest rate cut will be offset by the burden on the banks. The fear of reaching that point explains why no central bank has ventured deep into negative territory.
To work around the problem, the ECB has improved its long-term repo operations (LTROs) that lend to banks. When they were introduced in 2011 during the euro area sovereign debt crisis, they were intended to allay fears about bank funding shortages. Since then they have been available in different flavors VLTROs – “very long-term” – to three rounds TLTROs or “targeted” operations in order to PELTROs, for the “pandemic emergency” announced in April. And the intent behind it has changed. TLTROs are one way of encouraging banks to lend to the private sector. The more credit a bank makes to households and businesses, the lower the rate to which it has access TLTRO Means according to one of the ECB. And in the perverted world of negative interest rates is that ECB pays banks to make loans to the economy.
This type of scheme is hardly unique. The Bank of England has something similar. But one trait does that ECBSetup novel. Until March the TLTRO Rate was tied to that ECBBenchmark interest rates. The connection has since been broken, however, and banks that meet the lending criterion can access funds at a much lower interest rate of -1%. The result is that banks can now get super cheap finance that produces a profitable spread when they use the proceeds on new loans. In the meantime, deposit rates stay closer to zero, so savers can’t run to the door.
So far it seems so TLTROs were popular and effective. While the Fed’s main focus this year was on supporting the capital markets, bank lending made up the bulk of the market ECBStimulus – hardly surprising given the much larger role banks play in brokering credit in the euro area. Until August 7th ECB had lent EUR 1.6 billion (USD 1.9 billion or 13% of the euro area) GDP) through its lending systems. In June alone, the banks lent 1.3 billion euros. Once you add them, Frederik Ducrozet from Pictet Wealth Management finds the ECBThe balance sheet grew faster than that of the Fed this year (see chart). In a June speech by Philip Lane, the ECBThe chief economist assumed that the measures alone, by averting a liquidity crisis, could prevent production in the euro zone from falling by three percentage points in the period 2020-22.
Proponents say double guessing could be even more powerful. There is no technical floor on the TLTRO Rate: It can drop to -5%, -10% or more. Lower interest rates could give inflation, which has long been subdued, the kick it needs. In the meantime, the central bank could start raising its deposit rate, satisfying critics in Germany and elsewhere who are concerned about the impact of negative interest rates on savers. The sliding scale for assessing who gets access to cheaper ones ECB Funding could be modified to, for example, improve the transmission of negative interest rates. Banks could be asked to reevaluate their existing loan books, suggests Eric Lonergan of M.&G Investments, a fund manager; in its most daring form, forever TLTROs could require banks to lend at negative interest rates – a way to send cash to citizens.
The art of the possible
Could double guessing become an integral part of the toolkit in some form? ECB and at other central banks? The obstacles can be political and not technical. If a central bank lends to banks at an interest rate lower than the rate at which it is paying reserves, it is making a loss. (In the ECBThese losses are likely to be more than offset by gains on asset purchases.) Most economists would suggest that losses do not matter. Central banks can simply print more money to pay their bills. In practice, however, central bankers have been cautious about losing money because they feared that government recapitalization might open them up to political pressure and control. You may also not want to be seen subsidizing greedy bankers with deeply negative lending rates: some commentators in France, says Mr Ducrozet, are already muttering that they are ECB does this. Perhaps, for a combination of reasons, Andrew Bailey, the governor of the Bank of England, told Bloomberg on August 6 that he did not expect to follow suit ECBGuide.
Double interest rates also don’t seem worth the effort when fiscal policy is the stronger tonic for an economy in recession. Even the European Union managed to relax fiscal policy this time. However, a quick, sufficiently large and targeted response from governments in the next downturn is not guaranteed. A lesson from the last decade of attempts to revive growth and inflation is that any incentive measure has a political disadvantage of one kind or another. If double interest rates accelerate the day the economy recovers enough to allow monetary policy to be tightened, then they are certainly worth it. ■
This article appeared in the Finance & Economics section of the print edition under the heading “Conscious Decoupling”.