Bankers Ponder the Consequences of a Likely ECB Rate Cut

Analysts expect euro zone rates to go deeper into negative territory, putting pressure on other European central banks to follow.


Martin Leissl

In the land of negative rates, people are bracing for further cuts.

Policymakers, bankers and investors across Europe are debating the likely fallout if, as expected, the European Central Bank goes ahead later this week and slashes interest rates even deeper into negative territory. Markets have been anticipating such a move since November 20, when ECB president Mario Draghi promised to use “all the instruments available” to avert the threat of deflation and stimulate growth in euro zone. “We will do what we must to raise inflation as quickly as possible,” he said.

Markets have already priced in another 10- to 15-basis-point cut in the ECB’s overnight deposit rate, which currently stands at –0.2 percent, when the central bank’s governing council meets on Thursday. Many analysts also predict the ECB will expand its quantitative easing program. Erik Nielsen, chief economist at Unicredit in London, expects the central bank will increase its purchases of government bonds by €500 billion to €800 billion ($530 billion to $850 billion).

By charging negative rates, which means commercial banks have to pay to deposit funds at the central bank, the ECB hopes to prod banks to put their money to work by lending more to businesses and consumers, stimulating the economy. Negative rates also tend to depress the euro, which makes European exports more competitive and puts upward pressure on euro zone inflation.

The ECB’s decision will have an impact beyond the 19-nation euro zone. Denmark, Sweden and Switzerland have imposed negative interest rates of their own in an effort to cushion their economies from the impact of a weaker euro, and analysts say they may match any ECB cut.

Policymakers at the Federal Reserve in Washington will also be watching Draghi closely. Most market participants to anticipate the U.S. central bank will hike rates when its Federal Open Market Committee meets on December 16, a prospect that seemed even more likely after chair Janet Yellen expressed confidence Wednesday that the American recovery would boost inflation back to her 2 percent target. But Fed officials have also expressed worries about global weakness sapping the U.S. economy; a stronger dollar would exacerbate those concerns.

Negative interest rates have never been used for long, and central bankers and economists don’t know where the lower limit is, the point beyond which distortions outweigh any salutary impact, such as depositors withdrawing funds en masse from banks and hoarding cash.

“Why the lower bound has yet to be reached, and how much more room there is to maneuver, is obviously crucial for the ECB and the other three central banks,” says Oliver Harvey, macro strategist at Deutsche Bank in London. Harvey says the lower bound has not been tested because European banks, with one or two small exceptions, have not yet passed on negative rates to their retail customers. But that may be about to change.

Within the ECB’s governing council, a further cut in rates is likely to be controversial because the move will have the greatest impact on German banks, which are flush with excess liquidity from the country’s current-account surplus, Harvey contends. Banks in the euro zone’s periphery have much less liquidity and thus will face less of the negative interest bill.

The Swiss National Bank will have a different set of concerns when it holds its next monetary policy meeting, on December 10. The SNB was the first major central bank to go negative, back in December 2014, in a bid to prevent the franc from strengthening against the euro. Markets are pricing in a likely 25-basis-point cut on sight deposits at the central bank, which would bring the reference rate to –1 percent.

Analysts note that the negative interest rates, although easing upward pressure on the franc, have hurt Switzerland’s banks, which have been loath so far to pass on the negative rate bill directly to their retail customers. The SNB has provided an exemption for some deposits, easing some of the pain on banks, but Emile Cardon, a senior market analyst at Rabobank, says that 98 percent of exemptions have already been used, meaning that any fresh rate cut will hit the banks hard.

“Swiss banks aren’t happy at the moment, because they have to pay overseas clients to get their business while paying the central bank negative interest on sight deposits, so they feel they have to be compensated,” Cardon says.

One way Swiss banks have been compensating for negative deposit rates is by hiking rates on mortgages, which account for 85 percent of private domestic loans in Switzerland. The ECB won’t want to see mortgage rates rise in response to a deposit rate cut, because it wants to stimulate growth, but the SNB has been happy at the reaction in Switzerland because higher mortgage rates are having a dampening effect on the country’s overheating housing market.

The central bank remains concerned about the strength of the franc, and analysts say the Swiss are likely to cut rates further if an ECB cut drives the euro down sharply against the franc. SNB board member Fritz Zurbrügg said recently that the Swiss franc remained overvalued and that monetary policy must be adjusted accordingly. He told an investor conference last month that negative rates, “together with the willingness to intervene on the foreign exchange market as necessary, make it less attractive to hold Swiss francs and thereby support a further weakening of the currency.“

A similar conundrum faces the Danish and Swedish central banks. Pernille Bomholdt Henneberg, euro analyst for Copenhagen-based Danske Bank, said Danmarks Nationalbank, which began setting negative rates in July 2012, had been all set to raise rates before Draghi’s comments but is now likely to do nothing after the ECB meeting. The central bank pegs the Danish krone to the euro at a rate of 7.46, plus or –2.25 percent.

One small Danish bank has started charging customers for deposits, whereas other banks are raising “administrative fees” to make up for the shortfall.

The Swedish Riksbank, on the other hand, is greatly concerned about the effect a cut in ECB rates will have on the “robustness of the upturn in inflation” and is likely to slash its benchmark repo rate by 10 basis points, to –0.45 percent, later this month, says Henneberg. The central bank aims to get inflation, currently running at just 0.1 percent, back to its 2 percent target in 2016.

“There is a lot of focus on currency rates in Denmark and Sweden,” she says.