The clamour for an ECB rate cut is remarkable because such a move would be ineffective and do nothing to help tacking the dis-inflationary forces in the eurozone. Five years on, investors still think central banks have the answers, but in many cases they don’t and the situation in the eurozone is a prime example of that. There are some better options on the table for the ECB this year.
Let’s deal with rates first. Never forget the difference between the ECB’s refinancing rate, the rates prevailing in the market (inter-bank) and those paid by households and businesses. Whilst the ECB’s benchmark rate is 0.50%, money market rates are below 0.10% out to 1-month duration. The ECB last cut interest rates in May of this year. The impact on actual borrowing rates to non-financial corporates was virtually zero, the ECB’s own composite cost of borrowing indicator falling from 3.01% to 2.93% (April to September). The same measure for households fell 6bp (from 3.12% to 3.06%) over the same period. A pretty similar picture exists for short-term loans, less dependent on market rates. A rate cut on Thursday would have a similar, if not even smaller impact on lending rates. The argument that it will boost confidence is also weak, because after all this time, households and businesses know the score with lending availability and rates (i.e. they won’t move).
The second issue is liquidity. Rates in the eurozone are much lower vs. the central bank rate because of excess liquidity caused by the ECB’s lending operations, which offer as much liquidity as banks want in return for specified collateral. This creates excess liquidity in the eurozone, funds over and above the amounts that banks are required to hold with the central bank. This has been as high as EUR 800bln and is currently EUR 175bln, the level at which the ECB has suggested money market rates will start moving higher. Why would banks that have been repaying loans back to the ECB take out new loans? The only way is to adjust collateral requirements (making them more favourable) or make the loans on more favourable terms. This at least reduces the pace of the run-off of lending being repaid, making it more gradual. The ECB has the option to either put out the details at this week’s meeting, or at least pre-announce the headlines, with details forthcoming in December or January.
The third option is a negative deposit rate, the rate at which banks are remunerated for parking money overnight at the ECB. At present, it’s zero and in ‘normal’ times, it was 1% below the main re-financing rate, acting as an incentive for banks to lend funds elsewhere, rather than park at the ECB. The thinking behind a negative rate is that this dis-incentive is enhanced again. Draghi seemingly warmed towards the idea in May (he had an “open mind”), in contrast to his earlier cautiousness (“unintended consequences… can be serious”). Since then, it appears to have moved down the agenda, not least as Draghi went for his own version of forward guidance in July.
But now could well be the time to move it back up the agenda. For starters, the average amount deposited back at the ECB has fallen by half since May. Back then, we suggested that it was better to introduce such a measure when borrowing was low, ensuring it acts more as a carrot (encouraging lending) rather than a stick (punishing those who do use the facility). It’s not going to have a major impact on the economy or inflation, but as Japan shows only too clearly, there are limits to what central banks can achieve in a balance sheet style recession. The longer it goes on, the more the onus falls on governments.