When Central Banks Try to Fix What They Break

The European Central Bank would only take interest rates more negative with a mechanism to soften the blow on banks

By Jon Sindreu

 European Central Bank headquarters in Frankfurt Photo: kai pfaffenbach/Reuters

Fears of a global economic slowdown have led the European Central Bank to once again ponder the idea of taking interest rates into deeply negative territory and then come up with ways so to cushion any ill effects. That last bit in itself should be a red flag.

Only a few months ago, investors expected central banks to keep tightening financial conditions after a decade of unprecedented stimulus. Now they think more easing is at hand. In the U.S., futures markets price in almost a 50% probability that the Federal Reserve will lower interest rates by January.

But the real problem is in the eurozone, where the ECB never lifted rates from their record-low minus-0.4%, and officials need to do something to signal that their arsenal isn’t spent. At their latest policy meeting last Wednesday, they suggested rates could go further below zero, accompanied by a tiered deposit mechanism designed to shield banks from the damage.

Even so, investors seem skeptical that eurozone banks can escape the fallout. Last month, mere speculation about negative rates weighed heavily on their shares.

Negative rates are like a tax on banks because they are charged for the reserves held at the central bank that they, on aggregate, can’t get rid of. It is true that some of their borrowing costs also go negative, but banks don’t dare charge for retail deposits—a big chunk of their liabilities—for fear of losing business. If deposit returns go negative enough, customers could always just ask for their money in bank notes.

A two-tier deposit system would seek to alleviate this by charging the more punitive rate only above a certain level of excess liquidity. This could create a range of new complications, though. For example, since banks in Northern Europe still hoard most of this extra liquidity, some short-term borrowing rates in countries such as Italy and Spain may not follow the ECB’s policy rate all the way down.

Embracing monetary complexity to solve problems is rarely a good thing for policy makers to do. Evidence from the past decade shows that the ability of unconventional policies like negative rates and quantitative easing to boost economic growth and inflation is limited.

When the next downturn comes, ECB policy makers should stop trying to fix what they themselves wreck. It would be better to simply pass the baton to fiscal policy.

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