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Central banks are still testing the limits to how low interest rates can go
Nov 28th 2015
IN JUNE of last year the European Central Bank reduced its benchmark interest
rate, at which it lends to commercial banks, to 0.15% and its deposit rate,
which it pays to banks on their reserves, to -0.1%. For a central bank that was
once cautious about unconventional measures, setting a negative interest rate
was a bold move. The ECB was in effect charging commercial banks to hold their
excess deposits at the central bank, in the hope that this would drive down
borrowing costs more generally.
Three months later, the ECB cut the deposit rate again, to -0.2%. When the ECB
s rate-setting council next meets, on December 3rd, it is widely expected to
trim the deposit rate even further, as well as to approve more quantitative
easing or QE (the creation of money to buy bonds). In a recent speech Mr
Draghi claimed that the ECB s unconventional policies over the past 18 months
had been the dominant force in spurring the euro-zone economy and staving off
deflation. Lending by banks is slowly reviving. Even so, he suggested,
deficient inflation and lingering concerns about the strength of recovery
justify further action.
Not so long ago, the lowest possible interest rate was thought to be zero.
There is a ready alternative to keeping money in banks: holding it as cash.
Mattresses do not charge for storing notes. Depositors might tolerate small
fees, to avoid the cost and hassle of making other arrangements but most had
assumed their tolerance would be limited. We are now at the lower bound,
Mario Draghi, the ECB s boss, said after the last cut. He now seems to be
reconsidering but how low can the ECB go?
The ECB is not alone in testing the lower bound to interest rates. Denmark s
central bank has set its main policy rate below zero for much of the past three
years to repel capital inflows that had threatened its exchange-rate peg with
the euro. In January the Swiss National Bank abandoned its attempts to stop the
franc from appreciating against the euro by printing and selling francs in vast
quantities; instead it resorted to negative interest rates to deter investors
from buying francs. Sweden s central bank, the Riksbank, took its main policy
rate negative in February, to weaken the krona, make imports more expensive and
thus push inflation closer to its target of 2%.
For all these countries, it is the exchange rate against the euro that matters
most. To suppress their currencies, their central banks must offer interest
rates that are further below zero than the ECB s. The deposit rate in Denmark
and in Switzerland is -0.75%. In Sweden it is -1.1%.
This has not caused commercial banks to swap their reserves at the central bank
for cash, as theory would suggest. That is because to do so would itself be
costly. To settle payments, banks must move vast sums between themselves each
day. The costs of counting, storing, moving and insuring lorry-loads of
banknotes apparently trumps the smallish charge Europe s central banks are
levying to hold electronic deposits. The other possible use for banks reserves
is to lend them to other banks, but they are already awash with the excess
liquidity created by QE.
The deposit rate at central banks sets a floor for the cost of overnight loans
more generally, which is why short-term money-market rates have also turned
negative. Indeed, negative policy rates and money creation through central-bank
purchases of bonds or foreign currencies have dragged the yields on sovereign
bonds into the red all over Europe (see chart). That in turn has pulled down
the interest rates charged by banks for new loans.
Banks have passed on some of the cost of negative rates to their corporate
clients. For them, too, the cost of moving and storing large stocks of cash is
prohibitive; the obvious alternative buying safe and liquid bonds also now
comes at a cost, thanks to negative yields.
This week Alternative Bank Schweiz, a tiny Swiss outfit, said it would be
forced to levy negative rates on personal accounts from January. Most banks,
however, have shielded retail customers from such charges, on the assumption
they would move their accounts elsewhere. As a consequence, overall bank
deposits have been stable. The banks have simply absorbed the cost of deposits
at the central bank, which has dented profits. A further cut in the ECB s
deposit rate of 0.2 percentage points could squeeze the net profits of European
banks by 6%, according to Autonomous Research.
As interest rates creep further into the red, economists prescriptions have
become bolder. In a speech in September Andy Haldane, the chief economist of
the Bank of England, outlined a range of options to allow rates to go lower
still. The most radical would be to get rid of the mattress option by
abolishing cash altogether. Ken Rogoff of Harvard University calculates that
there is $4,000 of currency in circulation for every person in America. Much of
it is used to hide transactions from tax authorities or the police. Abolishing
it would curb such activities, as well as helping central bankers.
Yet depositors might still find ways to safeguard their savings. Switching to
foreign currency or precious metals would be an obvious option. As Kenneth
Garbade and Jamie McAndrews of the Federal Reserve Bank of New York point out,
taxpayers could make advance payments to the taxman and subsequently claim them
back. Depositors could withdraw funds in the form of bankers drafts (certified
cheques) to use as a store of value. Such drafts might even become a form of
parallel currency, since they are transferable. Any form of pre-paid card, such
as urban-transport passes, gift vouchers or mobile-phone SIMs could double up
as zero-yielding assets. If interest rates became deeply negative, it would
turn business conventions upside down. Companies would seek to make payments
quickly and receive them slowly. Their inventories would grow fatter.
In practice, euro-zone banks are the ones on the front-line of negative rates.
That is sparking worries that, if rates go too low, they might harm the
economy. Banks that are nervous about the stability of their deposits are less
likely to lend, says Huw van Steenis of Morgan Stanley, an investment bank. Yet
pushing rates lower still is also likely further to weaken the euro against the
dollar, especially as the Federal Reserve seems set to raise its main interest
rate on December 16th. That may even be the ECB s main motive just as
suppressing their currencies is the explicit aim of the other members of the
negative-rate club.