Through the looking glass and into Europe

A hint by the European Central Bank that it would consider imposing negative interest rates on deposits has rightly spooked financial markets.

The search for normality in Europe looks set to be a long and arduous one. The strange days are far from over.

The ECB did do one unsurprising thing last night, cutting its refinance rate by another 25 basis points to 0.5 per cent – a new record low.

Its first move in 10 months, the cut was vindicated by more bad news emanating from euro area manufacturers. The eurozone’s Performance of Manufacturing Indices for April revealed the manufacturing sector in continued contraction. The total eurozone index was 46.7 for April, indicating further shrinkage in the world’s largest economy.

Spain’s PMI rose slightly in the month to 44.7. But the German PMI actually fell in the month, slipping from 49.0 to 48.1.

Not surprisingly, investors were buoyed by the prospect of lower interest rates in Europe, and markets rallied. While this latest cut will come too late to engineer much of a recovery in euro activity this year, it helps to set things up for a better start to 2014.

But market relief was short lived after ECB President Mario Draghi set the cat among the pigeons by announcing about halfway through his press conference that the ECB has “an open mind” about the possibility of negative deposit rates.

Presently, the ECB’s deposit rate is set firmly at zero per cent, meaning banks who park their money at the central bank get no return on their money.

It’s a sign of the times when earning zero return on your money is the best investment in town - at least you’re not losing money.

But with activity levels plummeting across the euro area and banks’ lending to businesses all but on ice, the ECB is being forced to consider more innovative ways to push creditors out from under its apron strings and into the real world of credit origination and growth.

Negative deposit rates would mean that banks would, in effect, pay a fee to the ECB for the privilege of being able to hold their money there.

The ECB would hope the banks would baulk at the idea and instead choose to lend out the money, thus stimulating the real economy.

But that is far from the only option confronting the banks. And it’s far from obvious that it would be the one they would choose.

For instance, banks could simply stop leaving overnight deposits with the ECB and simply hoard paper themselves.  

A more troubling prospect would be if banks shrugged their shoulders and continue to deposit cash with the ECB and shoulder paying the negative interest rate as a fee for the service. This would be an extra cost to banks which they could then choose to pass on to existing borrowers as higher interest rates. This, of course, would be the exact opposite of what the ECB would be seeking to achieve and could potentially crunch real activity even further.

Welcome to life at the zero bound. What to do when your interest rates are already at or near zero per cent?

The ECB has held out the possibility of further cuts to its refinance rate, as needed. 

But at 0.5 per cent the monetary cupboard is almost bare. In such a world, it is incumbent on a central bank to consider what it will do next to feed starving economies.

But it is far from clear that negative deposit rates are the answer. 

While the intended effect may be to force banks to go forage for extra food by lending to finance-starved businesses, it could turn out to be the equivalent of imposing a new hunger tax on those businesses least able to afford it.

The experience of Denmark, one of only a few central banks that has ever dabbled with negative deposit rates (of -0.25 per cent) is not encouraging in this regard.

The most obvious solution, of course, would be for the ECB to follow the lead of the US Federal Reserve and begin printing money by buying up government bonds.

It’s a course of action that the ECB has so far resisted, with Draghi insisting later in his press conference that his central bank “doesn’t go around with helicopter money”. 

But as the US economy recovers thanks to its extraordinary quantitative easing, while formerly strong European economies like Germany get dragged down by the European undertow, this obstinance is striking. 

It simply prolongs what already looks to be a full-blown depression in Europe.

Draghi and the Troika may not be ready to admit it yet, but it is clear the ECB’s work is far from finished.