Rates of Interest at the ECB

euro inst

Today, the European Central Bank (ECB) announced a cut in the interest rate that it charges when it lends money to commercial financial institutions like banks. With falling inflation (a signal of a sluggish economy when extra low) and record high unemployment in the eurozone, this drop in the refinancing rate, from 0.75 percent of 0.5 percent, was expected. The idea behind cutting this interest rate is to lower the cost of borrowing for banks, so that those banks can then charge a lower interest when they lend to firms and households. Many of these firms and households, especially those across Southern Europe, face high borrowing costs which, overall, does not help growth and employment.

It is unclear how effectively this rate cut will translate into cheaper borrowing costs for those who need it the most. One of the main issues facing the eurozone today is the large difference in interest rates paid by borrowers in Southern Europe (namely Greece, Italy, Portugal and Spain) and by those in Germany, for example. In the eurozone, the divide between countries in the north and south is a major obstacle to the recovery of this group of countries that are bound together by a common currency.

The cut in the ECB refinancing rate was expected and is welcome, but investors reacted to comments made by ECB president Mario Draghi on a different interest rate that the central bank also sets. In addition to the refinancing rate, the ECB also sets a deposit rate, which is the interest rate that banks receive for their deposits at the central bank (similar to an interest rate an individual receives from a bank for holding their savings, or deposits, there). Currently, the ECB’s deposit rate is set at zero so as to not encourage banks to park their money at the ECB and ideally lend the money out into the real economy.

As signaled by the cut in the refinancing rate, the ECB is trying to further encourage lenders to lend as conditions in the eurozone remain sluggish. In the same vein, ECB president Mario Draghi said in today’s press conference that the ECB has an “open mind” on dropping the deposit rate below zero into negative territory. A negative deposit rate means that instead of banks receiving interest on their deposits (parked money) at the ECB, they would have to pay interest on those deposits. The idea is to provide a disincentive for banks to park their money at the ECB, with the hope that they will lend more to firms and households.

The rate is still zero, but Draghi’s “open mind” to consider negative deposit rates is a strong signal to the markets that those rates could go negative in the future. The hope by the ECB is to encourage a more liquid banking sector, but it is not clear that banks would react by lending more. Banks could, for example, decide to raise interest rates on firms and households to make up for the cost of holding their own deposits at the ECB.

Markets reacted to Draghi’s comments by moving away from the euro currency, dropping its value almost 1 percent against the dollar within one day. This is perhaps a signal that the markets expect negative deposit rates to become a reality and for that policy to be effective, resulting in more euros in the economy and thus a diluted value.

It is in the global economy’s interest for the eurozone to get back up on its feet. Let’s hope these bold moves (or bold announcements) of the refinancing rate cut and open-mindedness on the deposit rate work as intended, and that fiscal policymakers show a similar kind of aggressiveness and action-oriented policymaking.

 

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