The European Central Bank (ECB) has announced that it will lower its benchmark interest rate to 0.15%, down from the previous 0.25%, and its deposit rate to -0.1%, down from its current rate of zero. The aim is to encourage bank lending and prevent deflation in the Eurozone. The changes will take effect on 11th June. The ECB is the largest bank to introduce negative interest rates and this is the first time one of the major four central banks (US Federal Reserve, ECB, Bank of England and Bank of Japan) have introduced, although they have previously been used in Denmark and Sweden. The move essentially means that retail banks will have to pay to hold money at the ECB. This strategy has been considered by the Federal Reserve and the Bank of England but both decided against the idea for fear of economic meltdown.
Deflation and Negative Interest Rates
The target rate of inflation set by the ECB is just below 2%, but in May inflation in the Eurozone dropped to 0.5%, its lowest rate since 2009. Mario Draghi, the president of the ECB, has stated he is prepared to take further action to prevent further decreases. Deflation means lower prices and lower wages in the economy which in turns encourages saving as consumers expect prices to be lower in the future. A drop in lending could mean bad news for European economies that have already begun to see a healthy but fragile economic recovery – growth would slow and unemployment would rise.
The negative interest rate should help to combat the increasing threat of deflation, as ideally it will encourage banks to lend more in search of a higher return and stimulate spending.
Possible Consequences
There are several speculations as to what could go wrong with this policy. Some believe that banks might go searching for riskier investments to secure returns, creating problems in the future if those investments go wrong. Other experts believe the negative interest rates alone won’t be enough to control deflation.
Although Denmark has attempted this strategy in the past, it has never been done on an economy as large as the Eurozone. The reason behind the drop in interest rates is also different, as Denmark introduced negative rates to stop the value of its currency rising against the Euro, not decrease deflation.
As this approach has never been attempted before on such a large scale, we can only speculate on the outcome. These are monumental policy changes and will be interesting to see the economic effects over the coming months.
Other initiatives being undertaken by the ECB include long-term refinancing operations (LTROs), low interest rate loans to banks to encourage them to lend to households and non-financial corporations and plans to buy asset-backed securities from banks. The ECB hopes that this will further promote lending to businesses and households to help achieve their goal. At present they have stopped short of quantitative easing as has been used in the US and UK, but this could be on the cards if things don’t start to tick up in the Eurozone.