In July 2012, the European Central Bank (ECB) lowered its deposit rate to zero, and some two years later it became negative for the first time at minus 0.1%. Since then, commercial banks in the eurozone have had to pay „penalty interest“ on surplus liquidity parked at their central bank. Only three months later, in September 2014, the ECB lowered the deposit rate once more to minus 0.2% and then again in December 2015 to minus 0.3% and finally in March 2016 to minus 0.4%. In March of last year, the main refinancing rate was also lowered to zero which meant that the commercial banks in the eurozone were now able to obtain the required central bank liquidity in normal tender operations without having to pay interest on this. Since then at the latest, money market rates and a considerable share of capital market yields in the euro area have been negative – to begin with an equally irritating situation for debtors and investors.
The ECB decided to adopt this policy in order to tackle the presumed dangers of deflation, prevent inflation expectations from falling further and bringing inflation in the eurozone back to a range of „below, but close to two percent“. Welcome side effects of this policy were economic stabilisation in the eurozone, a weaker euro against other currencies as well as support for the eurozone countries burdened by high debt.
However, the hopes associated with the policy of low, zero and negative interest rates have only been partially fulfilled. Until now, the ECB’s policy has had only a very slight impact on the real economy. Inflation expectations have risen, but the actual increase in inflation is attributable to the base effect of the oil price; the core rate, on the other hand, has remained essentially unchanged.
But the zero interest rate policy and negative deposit rates have had adverse implications for the banking system. Negative interest rates cannot and should not be passed on directly to the customer so that pressure is exerted on the interest rate margin. A psychological effect is also increasingly playing a role here. Interest is the price paid for money, and if the interest rate is zero or negative, it soon emerges that the money saved is worth nothing and that the credibility of monetary policy and of the ECB will be undermined in the long term.
It is now becoming apparent that the real source of the positive impact of ECB policy is the asset purchasing programme, which is having tangible effects on capital market yield levels and on the credit spreads of sovereign states and corporates. What is more, falling yields and narrowing spreads had positive valuation effects for banks‘ balance sheets, creating windfall profits and contributing towards stabilising the banking system in the euro area.
This positive effect on the banking system is now gradually drawing to an end, the marginal utility familiar from microeconomics is in decline given the economic senselessness of narrowing spreads even further which could only be achieved at great expense (i.e. a further massive expansion of quantitative easing).
Banks can therefore expect to generate correspondingly lower returns in the years ahead – with in some cases undesirable repercussions for equity capital. Banks’ earnings must now derive from the operating core business. The natural earnings power of banks will thus be put to the test in the years ahead, thereby revealing which banks have a self-sustaining business model and which don’t. A glance in the direction of Italy suggests how things could develop. This will reignite the discussion about the stability of the banking system.
Should yields and credit spreads suddenly surge upwards, the banks‘ previous valuation gains would shift clearly into reverse. Rising yields in the USA could accelerate this development even more. It would therefore be advisable to keep the volume of asset purchases stable for the time being or only lower them slowly and prudently. Were the ECB to introduce aggressive tapering, the adverse valuation effects would generate losses in the annual financial statements. Thus, the only real possibility open to the ECB is to taper the asset purchasing programme very slowly at the outmost.
On the other hand, the economic development in the eurozone has now stabilised again noticeably. The growth weakness still apparent cannot be attributed to cyclical factors but has structural causes, which means that it cannot be effectively tackled either by monetary or fiscal policy. The inflation rate has departed the negative zone again and can be expected to rise further in the months ahead, with the argument of tackling potential deflation risks becoming less relevant in the process.
So the time has come for the ECB to wind down its ultra-expansionary monetary policy. It would therefore do well to consider raising key interest rates again in the very near future so that the deposit rate can quickly depart the negative zone thus enabling investments on the money market to generate positive returns again – a clearly welcome prospect, not just for small savers, given the prospect of gradually rising inflation rates. It would also mean that the liquidity holdings of the commercial banks desired by politicians, the ECB and the regulator, would no longer be subject to penalty interest.
The time has come to end the ultra-expansionary monetary policy, but this will not be an easy task. However, this balancing act could be achieved by means of a rapid normalisation of key interest rates and a gradual tapering of the bond purchasing program.