The Business Week that was
The European Central bank moved to negative interest rates, while our own central bank officially did nothing with theirs but actually allowed monetary policy to ease 10 points. Michael Pascoe comments.PT4M59S http://www.canberratimes.com.au/action/externalEmbeddedPlayer?id=d-39oc3 620 349 June 6, 2014
The European Central Bank (ECB) took the highly unusual step overnight to introduce negative rates in the eurozone. But while that may have grabbed the headlines, negative rates were only one of a handful of measures announced by ECB president Mario Draghi.
Mr Draghi's strategy essentially revolved around two things: cutting rates and adding more liquidity to the market.
Mario Draghi, president of the European Central Bank. Photo: Bloomberg
He did this by introducing negative deposit rates, a cut to the main refinancing rate, a cheap loan known as long term refinancing operation for banks, and an end to so called 'sterilisation policy.'
All of these measures are aimed at making money cheaper to borrow and therefore more freely available - to help stimulate economic activity. It makes the euro a less valuable currency and so makes other currencies like the Australian dollar more attractive.
Let's look at each measure in turn:
Negative interest rates
Negative interest rates are exactly what they sound like – depositing money actually attracts a charge rather than earning interest. In this case, the negative rate is applied when Europe's commercial banks deposit with the ECB.
The idea of this is that the banks will not deposit any more than necessary with ECB and instead will lend the money, or invest in more profitable activities with a higher return.
What does this mean for bank customers? It depends on the bank. It might lower or charge its own negative interest rates, keep them the same and eat the loss, or charge interest indirectly through higher deposit fees.
Commonwealth Bank chief currency strategist Richard Grace estimates that there will be €124 billion of excess liquidity (cash) as a result of the negative interest rates move. This gives banks three options: lending the money into the economy (which the ECB wants), parking it in interest-paying German bunds or French bonds, or shuffling it into higher-yielding assets such as the Aussie dollar.
Grace stresses that it's the commercial banks that decide whether to pass on the negative interest rates on to their customers. Switzerland is one country where the central bank briefly introduced negative interest rates on deposits and commercial banks followed suit.
Cutting the ECB refinancing rate
The ECB's "refi rate", as it is known, is basically the ECB's equivalent of Australia's official cash rate set by the RBA each month
But where Australia has kept its official cash rate at the historic low of 2.5 per cent for 10 months, overnight, the ECB dropped its rate by 10 basis points to 0.15 per cent.
By doing this the ECB hopes to trigger a widespread drop in interest rates for all kinds of loans and credit across the continent. The "refi rate cut is an attempt to lower all interest rates", as CBA's Grace says.
While the negative rates have grabbed the headlines, it's this attempt to push down interest rates right across the economy that means the "refi" rate cut is actually the most important measure announced.
The ECB has also announced a cut in its marginal lending rate, which is the rate at which banks can make fresh short term borrowings.
€400 million in new loans
Specifically, this announcement is for €400 billion of new 'targeted long term refinancing options' (TLTROs). These are low interest, long term refinancing loans to boost lending in the "real economy". They are only available to the non-financial sector and exclude household mortgages.
They are also substantial: from March 2015, all banks will be able to lend up to three times their quarterly net lending to the non-financial sector in the eurozone
In essence, the TLTRO is a cheap loan to banks that they have to lend to specific sectors of the real economy - a lot of small and medium businesses, and not in the financial sector or household mortgages. The loan matures in 2018, but banks who do not lend sufficient cash to the correct sectors will be required to pay it back in 2016, two years early.
This is the most complicated policy change. SInce 2010 the ECB has conducted a 'sterilisation' program. Instead of simply pumping liquidity into the market like the US, UK and Japanese central banks, the ECB chose to offset its purchases to keep the overall money supply stable.
It did this by offering banks interest bearing deposits equal to the amount of bonds it held each week, thus stabilising the money supply. For every government bond the ECB bought from one the the 'Club Med' countries (Greece, Ireland, Portugal, Spain and Italy), it tried to withdraw an equal amount from banks through these interest bearing deposits.
The policy also also meant that the ECB could claim it wasn't quantitative easing because the money supply remained stable.
The weekly sterilizations have been a drain on bank balance sheets, so ending the policy means that cash stays in the banking system to be facilitate economic activity. It is a fundamental change from the policies of the past four years and a sign that the ECB is one step close to full blown quantitative easing.
These moves are an attempt to inject liquidity – ie more money - back into markets and stave off deflation in Europe.
In a possible further step in the direction of quantitative easing, Mr Draghi also signalled that the ECB is working on a program to purchase asset-backed securities. He didn't however suggest the ECB would resort to large-scale buying of government bonds, as in the US, UK or Japan.