Lend or be damned. That was the message from the European Central Bank today after it cut the deposit rate by 25 basis points to 0%, in a bid to force banks to increase their lending in the interbank markets. In addition to cutting the refinancing rate by 25bp to 75bp, as expected, the ECB has surely signalled to the markets that a low interest rate regime is here to stay and the bulls might see today’s moves as a pre-cursor to full-scale quantitative easing.
However, analysts warn that the rate cuts not only risk fuelling financial dysfunction but are also unlikely to have any strong effect on the eurozone's growth and inflation outlook.
On the latter point, and according to Nomura’s proprietary eurozone monetary model, a 25bp cut in the refinancing and deposit rates will increase the harmonised index of consumer prices (HIPC) by 0.04 percentage points and economic growth by 0.25% after three years. In other words: such cuts would have very little impact in the current macro-economic environment. What’s more, few believe the monetary transmission channel is sufficiently robust, a point made by ECB President Mario Draghi at the last press conference.
Meanwhile, the risks are potentially considerable. In Nomura’s words – one of the few research houses to get the deposit cut call right.
1.The move could challenge the technicals of money market trading:
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“Can all trading and payment systems handle 0% interest rates, or are there operational risks that some banks may not have the technical infrastructure in place to handle this? Market participants have coped with negative Swedish and Swiss interest rates. Recently the Danish central bank stressed that it has the instruments to handle potential negative interest rates (link). That said, the euro-area money market is considerably larger and the Eurosystem central banks cannot run the risk of even a minor market disruption.”
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2. Bank profitability – under siege by a lack of positive carry on alternative financing instruments – will take a knock, unless it can use cheap financing to on-lend in the real economy, or, dare we say it: peripheral sovereign bonds:
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“If the deposit rate is cut to zero there is no incentive for banks to use the ECB deposit facility, meaning excess deposits can be left in banks current accounts. Cutting the deposit rate to zero therefore could trigger changes to how banks manage their liquidity flows. And a 0% deposit rate removes the 25bp remuneration that European banks receive for their excess reserves sitting in the ECB's deposit facility. Hence, a deposit rate cut in isolation (i.e. assuming the policy rate stays unchanged) hurts the profitability of the banking sector.”
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“Greater disintermediation on the money markets...With money market rates close to zero, the compensation for lending in the interbank market may not be sufficient to compensate for counterparty risk. Instead, market participants will choose to borrow from the ECB instead. The end result would be more reliance on ECB borrowing and the ECB would increasingly become the sole provider of money market liquidity. This would prolong the ECB's exit strategy; something the ECB is not comfortable with.”
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4. And the hawkish point made by those balance sheet recession fashionistas, as well as the Bank for International Settlements:
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“Pushing interest rates to their de facto lower bound could signal that rates will remain low for a very low time. The ECB is aware that this could lead to new lending bubbles and may delay the inevitable deleveraging process. Short-term concerns may require very low rates but this can fuel longer-term financial stability issues.”
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Nevertheless, the Swedish example highlights that monetary market rates tend to fall with flat or negative central bank deposit rates, thus the second-order benefits of the rate cut – boosting risk appetite – could outweigh the negatives, as noted above. Ultimately, economic theory suggests a fiscal stimulus in Germany to boost domestic demand would be the most effective measure to boost the eurozone. But political theory, and today’s ECB moves, reinforces the view that an expansion of ECB’s balance sheet is the only game-changer in town. Meanwhile, the likes of Bill Gross of Pimco fame will no doubt be screaming, listening to The Vapors.