Europe and other parts of the world are in for big risks.
Desperate times call for desperate and somewhat speculative measures. The European Central Bank (ECB) cut its deposit rate last Thursday, pushing it deeper into negative territory. The move is not unprecedented. In 2009, Sweden’s Riksbank was the first central bank to utilize negative interest rates to bolster its economy, with the ECB, Danish National Bank, Swiss National Bank and, this past January, the Bank of Japan, all following suit.
The ECB’s latest move, however, was coupled with the announcement that it would also ramp its Quantitative Easing measures by increasing its monthly bond purchases to 80 billion Euros from 60 billion Euros — a highly aggressive policy shift. The fact that the ECB has adopted this approach raises two key questions: What are the risks? And, if the policy fails, what other options are left?
Negative rates are an attempt by the ECB to prod commercial banks to lend more money to businesses and consumers rather than maintain large balances with the Central Bank. In essence, it is forcing the banks to leverage its balance sheet to a higher level or the ECB will penalize the banks by charging interest on their deposits. Historically, such a practice would be highly inflationary, however, with oil prices falling to record lows combined with a slowdown in global growth, inflation is not feared. In fact, inflation is desired at a manageable level, as this would promote near-term growth in the economic markets.
This does not mean, however, that the ECB’s policy does not present risks. First, if the commercial banks decide to pass on the cost of the negative rates to their customers — in other words, they charge customers for keeping their savings in the bank in the same way central banks are now charging the commercial banks for keeping their money – the customers might simply withdraw their savings. In a worst-case scenario, this could create a run on the banks in Europe with customers hoarding their money rather than paying interest on deposits. This would inhibit the free flow of funds through the financial system — ironically, the very reason that negative interest rates were implemented in the first place.
Read the full post at Fortune.
Charles Kane is a Senior Lecturer in Technological Innovation, Entrepreneurship and Strategic Management Goup and also in the Global Economics and Management at the MIT Sloan School of Management.