The ECB’s Negative Interest Rate

Among other easing measures, the ECB has cut the interest rate on its deposit facility to minus 1/10 of one percent, from an implied rate of zero. This is new territory and I’m eager to see how it works out.

At first blush it seems odd to charge banks for depositing money at the central bank, in effect requiring the banks to pay for the privilege. On second thought, however, minus 1/10 of a percent isn’t all that much lower than zero percent. More importantly, everyone by now is used to earning negative real interest rates on our deposits at banks since the close to zero nominal rates are negative in real terms even if inflation is very low. Any positive inflation under recent market conditions means our savings deposits and CD’s are earning negative real rates, not to mention our demand deposits earning zero. These considerations lead me to believe that the impact of this change will hardly be noticeable. However, together with the other easing moves, and the anticipation that all together they will weaken the Euro, these measures are likely to provide a boost to the Euro economy and provide some insurance against deflation.

What about applicability of this move for the Federal Reserve, which currently pays one-fourth a percent interest on bank reserves on deposit at the Fed? There are opposing considerations at work. As a matter of fairness to banks that were required to hold idle reserves at the Fed without compensation, the during my day lobbied Congress for the authority to pay interest on reserve deposits. That authority was finally enacted into low and its implementation date was moved forward at the beginning of the financial crisis. Given that history, if I were still there, I would be very reluctant to reduce that rate as far as zero, much less go negative.

On the other hand, excess reserve deposits built up at the Fed are at the heart of the problems the Fed’s easy monetary policy has had in stimulating more bank lending and thus faster growth of money and credit. The Fed’s measures to create more reserves for banks have had only a weak result because of banks’ reluctance to lend or invest those reserves more aggressively. (Of course, the weak demand for loans has also been part of the problem.)

The most direct thing the Fed could do to break the logjam would be to see what happens if it reduced the interest it pays, and possibly to follow the ECB’s lead in making it a penalty rate in nominal as well as real terms. The last time I looked, the M2 money supply has grown only at a 6.9 percent rate during the past three months, about the same as in the last few years. Normally 6.9 percent money growth would be excessive, but that has been partially offset in recent years by a three to four percent decline in M2 velocity. As I noted in my previous post, the decline in velocity in the first quarter almost entirely offset money growth to allow for only a 0.3 percent nominal GDP growth. If this continues, the Fed may be forced to follow the ECB’s lead—which is a turnaround from recent experience.

Comments (25)

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