Leading the ECB down a rabbit hole?

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On 22 January, the European Central Bank is holding its first meeting of the year and is widely expected to unveil quantitative easing. Has the SNB started a move that will drag other major central banks ‘down the rabbit hole to a ‘Wonderland’ of negative interest rates?

And if so, will the end result be a release of inflationary pressure across leading markets? Russell Silberston, head of Reserve Management at Investec Asset Management comments.

It seems likely that it was the enormous size of its balance sheet that stood behind last week’s SNB action. Yet arguably, the more interesting decision taken by the SNB last week and perhaps the most far-reaching was the reduction in its target range for three-month Libor to between -0.25 to -1.25%.

When the SNB first introduced negative interest rates in December 2014, it implemented it by imposing a negative interest rate on sight deposits, with the aim of “taking the three-month Libor into negative territory”. It would appear that the further reduction announced on 15 January will be implemented in the same way and so the CHF315bn sight deposits outlined above will now be charged -0.75%, the midpoint of the new target range.

Breaking the last taboo – the zero lower bound to interest rates

We believe the significance of the SNB’s action is that it appears to have broken the last taboo in the current era of extraordinary monetary policy operations, namely the zero lower bound to interest rates. In a global context, the Swiss bond and money markets are small. However, both the Bank of Japan and the ECB are actively or intending to expand their balance sheets via asset purchases.

These two banks represent major economic powers. They both view quantitative easing as an alternative to loosening monetary policy once interest rates are at or close to zero.

Implications for the forthcoming ECB meeting

It should be noted that the ECB’s Deposit Rate, which it applies to its equivalent of SNB sight deposits, is already -0.2% and there are reports of some commercial banks imposing negative interest rates on household deposits. What though, if the SNB’s latest action doesn’t actually distort the money market as much as theory would suggest? Why then stop at -0.75%, why not -2%? A Taylor Rule analysis, which provides a guideline for appropriate interest rates, suggests interest rates for the euro zone should be deeply negative given current deflationary conditions.

Were other central banks like Alice to sip from the bottle labelled ‘Drink Me’ that shrinks all interest rates, the implications would be enormous. A 10-year German bund with a yield of 0.45% suddenly looks attractive, assets with no income, such as gold, become carry trades and holding physical cash becomes more attractive, assuming commercial banks begin to impose negative deposits on household deposits.

Most intriguingly, were households to spend their deposits more quickly, the velocity of money would rise and might finally deliver the higher inflation that so many people have feared would be the consequence of the extraordinary monetary policy actions the world has been experiencing in recent years.


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