ECB mulls prospect of negative interest rates

The headquarters of the European Central Bank in Frankfurt Photo: Daniel Reinhardt/DPA/Press Association Images

Savers know to their cost that rock bottom interest rates in Britain have delivered miserable yields for years. But imagine if you actually had to pay the bank for the privilege of depositing your money. That is the prospect facing eurozone banks themselves if the European Central Bank cuts one of its key interest rates from zero to minus 0.1 per cent.

This highly unorthodox step has never been tried by a central bank with the scale of the ECB and is a signal of how worried policy makers are about the health of the eurozone economy. Specifically, they're worried about inflation - or the lack of it.

Prices are rising only 0.5 per cent across the single currency area, well below the ECB's target of "close to but below 2 per cent." Inflation was always the beast to be tamed so why worry about low inflation?

Two reasons are exercising economists: inflation erodes the value of money - that's bad if you have lots of cash but a huge help if you owe debt - and, after the crisis, many eurozone countries have debt by the bucketload. It's racking up interest and governments are struggling to pay the debt down. A bit of inflation would help a lot.

Economist are hoping prices will go up so the value of countries' debt falls. Credit: Inga Kjer/DPA/Press Association Images

Secondly, leaving inflation at such low levels runs the risk of it turning into deflation: prices actually falling. In fact this is already happening in some countries like Greece. Again, falling prices sounds like nirvana - if you wait long enough you could live like a King. But consumers and businesses quickly learn to put off until tomorrow what they could buy today, economic activity grinds to a halt and soon everyone is worse off.

So today, after half a year of talking tough we expect the ECB to act. The main rate which is used as a benchmark for consumer borrowing could be cut from an already low 0.25 per cent to 0.1 per cent. And the overnight deposit rate, where banks park their excess cash, could even be made negative. The ECB may try to get more bang for its buck (or euro) by launching some other activity like long term loans for banks at very cheap rates.

Will it work? Perhaps. Cutting interest rates will make it less attractive to hold euros. That lack of demand should make the euro weaker against other currencies like the US dollar. That, in turn (I never said this was easy) will make it more expensive to import things into the Eurozone. And more expensive is another way of saying ‘inflation’. Presto.

A secondary effect might be to encourage the banks to lend cash into the real economy instead of sitting on deposits. Small and medium sized companies in some countries are still finding it hard to get hold of loans.

It’s less clear whether this would work in practice and there may be some problematic unintended consequences: that negative interest rate may simply be passed on to bank customers in the form of higher interest rates on the loans they need. Not ideal in a Eurozone struggling to recover.

Ultimately, the biggest effect today may simply be in investors’ and consumers’ minds. The president of the ECB managed to yank the single-currency area back from the brink in 2012 simply by promising to do “whatever it takes” to save the euro. By taking some steps today and earnestly hinting he could do much more, he may turn the tide again.