In June of 2014, the European Central Bank (ECB) set negative interest rates on deposits. In February earlier this year, the Swedish central bank set its benchmark interest rate in negative territory in an effort to defend against economic and political uncertainty in Europe. The bold move demonstrates the growing fear of deflation. Denmark and Switzerland have also joined in. A third of the eurozone now carries negative yields on government bonds.
American banks keep money with the Federal Reserve. Likewise, European banks keep their money with the ECB. The idea behind near-zero deposit rates is that the bank can potentially profit more by lending their money elsewhere than it can with the money just sitting in the ECB reserve. Negative deposit rates essentially signals the same concept but with a louder voice. By reducing rates even further into negative territory means the ECB is actually charging banks for holding surplus deposits. And yet, this doesn’t explain why individual investors would want to continue lending.
Cutting interest rates has always been intended to encourage borrowing to fight deflationary pressure, but now investors must pay to lend, a concept rather mind-boggling. However, when we look deeper, we can understand that investors are not paying to lend. Rather, they are paying for safety of the debt in the face of looming market uncertainty. Furthermore, the liquidity of today’s markets allows investors to get in and out quickly if necessary.
Both the ECG and sovereign banks hope for the same outcome in foreign-exchange markets. Perhaps negative rates will make investment into the eurozone less lucrative, sending investors abroad and depreciating the currency. Following a depreciated currency, prices of imports would increase and exports would become more competitive, both increasing growth and inflation.