Negative Interest Rates from the European Central Bank
To spur growth and stave off the potential of deflation, the European Central Bank (ECB) took an unprecedented step last Thursday by establishing a negative interest rate. Starting on June 11th, instead of paying interest to commercial banks for keeping deposits in the ECB, banks will have to pay 0.1% to keep their money there.
To the layperson, this sounds moderately insane. Why would a bank offer a disincentive for you to keep your money there? For a commercial bank, that would be insane – but this is the bank for banks, if you will. What the ECB is saying is, "Don't keep your excess money here, put your funds to work making loans and spurring growth."
Mario Draghi, the leader of the ECB, announced the -0.1% rate on deposits with the central bank as part of a three-pronged growth strategy. The ECB also cut their benchmark interest rate to a new low of 0.15% and introduced a 400-billion euro funding package for banks available only for business loans (not mortgages or financial-sector transactions).
Growth has been limited in the EuroZone – the GDP was 0.2% in the last quarter, with only Germany saving it from outright contraction. Currently, inflation is at 0.5% and ECB staff expects it to only grow to 1.4% by 2016, well below the target mark of 2%.
Wait…Inflation is Good?
Like a fine liqueur, the answer is yes – but only in limited amounts. Relatively low, managed inflation is a byproduct of sustainable, moderate growth. The opposite economic condition, deflation, is a far bigger problem. Deflation inhibits growth because both consumers and businesses hold back in spending, assuming prices will fall further…which they will, because nobody is buying…and off the cycle goes. Nobody spends, and nothing grows.
The ECB's approach stands in contrast to the US approach of "quantitative easing" – while both are slashing the short-term interest rates to near zero, the policies diverge there.
The US has been buying bonds, effectively pumping money into the system in order to keep interest rates low and spur growth. So far, the results have been steady but unspectacular growth. For example, in the past week the 4-week moving average of jobless claims continued to drop, the unemployment rate held at 6.3%, and May non-farm payrolls gained 217,000 – pulling employment back to pre-Great Recession levels. The Fed is not ready to declare victory yet – nor should it. Too much stimulus money is stuck in the banking system, just as it is in the EU.
Meanwhile, the ECB has avoided the direct stimulus approach – partly because of the headache of distributing this stimulus evenly throughout the separate EU countries, partly because the bank's mission discourages buying bonds from individual governments. Yet Mr. Draghi stated that the bank was not finished acting and that they would "intensify preparatory work related to outright purchases." In other words, if they are pushed to stimulus purchases, how are they going to do it?
Denmark tried the negative interest rate experiment in 2012 with virtually no effect on the economy. It remains to be seen what will happen with this much larger-scale implementation.
Economists will likely be studying the two approaches for some time after the fact. Which one worked better, and did either work at all? Certainly, ECB officials will be studying what happens when the Fed halts its stimulus buying.
Some analysts suggest that the ECB won't wait to see the American results, and will enact some form of stimulus out of necessity. Assuming the ECB follows through with stimulus, European bank stocks (and eventually European businesses) should benefit from the influx of liquidity. If you want to follow that route, follow the ECB actions closely over the next few months for signs of an upcoming stimulus package.
Meanwhile, the negative interest rates alone should drop the Euro, so if your holdings are affected by a Euro valuation change, plan accordingly. At the same time, economic stimulus in the EU should boost American exports across the pond, benefitting companies – and their shareholders – who sell products there.