Going Negative

So much for the zero-bound.

On Thursday the European Central Bank lowered the interest rate it pays banks on their reserve balances to negative 0.1%. Now it will charge banks money for keeping balances with the ECB. Economists used to discuss negative rates the same way engineers talked about flying cars: possible in theory, but just not practical and never seen in reality. But several advanced labs are working on practical flying cars, and the world’s second largest central bank has now gone to negative rates. What’s next, warp drive?

Before we talk about what the measure will do, let’s talk about what it won’t do. It won’t immediately spur lending, as many commentator suggest. That’s because reserve banking is, in the short run, a zero-sum game. When a bank makes a loan, the money doesn’t disappear. It just gets transferred from one bank to another. The banks may play “hot potato” with the money, but some bank somewhere is stuck with the balance and has to pay.

What it will do is cut interest rates on short-term government bonds, like it did in Denmark two years ago when they went negative. That had the effect of pushing yields on Danish T-bills into minus-land. Eventually, Euro-land banks may put their money into riskier assets, but they also face stress-tests and other anti-risk pressures from their regulators.

In real terms, short-term rates have been negative a long time, with inflation higher than bank rates. Now, with the ECB paying negative nominal rates, rates are low enough to make our heads hurt.

Douglas R. Tengdin, CFA

Chief Investment Officer

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