(Jan 17, 2015)

Having kindly picked me up from Heathrow Airport just before Christmas, my brother pulled into a petrol station to fill up his car. Having seen that the petrol price had in fact gone down from an outrageous £1.30 to a less punishing £1.22 per litre he audibly exhaled with relief. The pound in his pocket going further is a respite that most of us can appreciate.

Approximately 400 miles away in Frankfurt, the same fact caused Mario Draghi to inhale with despair. A high oil/petrol price is an important cause of inflation. As President of the European Central Bank, he must have inflation no matter what. But how to cause it?

The man who had saved the European Debt Crisis in 2011 simply by vowing to do ‘whatever it takes’ knows that 2015 promises to be a tough year. He must try and prevent another debt crisis and the most important factor is to keep Debt to GDP ratios down. Given that getting governments to spend less is difficult the only other option available is to increase GDP, either through growth or inflation. How that number goes up really doesn’t matter – so long as it does.

The ECB is rather different from its/the other, more independent Central banks of the US, UK, China and Japan. Draghi envies their independent, ‘print as much money as we fancy’ freedoms. Bound by inconvenient rules and dominated by the Germans who still believe in outdated ideas of ‘trying to only spend approximately what you earn’ he has been largely denied the ability to use ‘quantitative easing’ and has instead been persevering with ‘Negative Interest Rate Policy.’ The ECB is not alone; Denmark and Sweden used negative interest rates in 2012 and Switzerland has also recently joined the club.

What is a ‘Negative Interest Rate Policy’ (NIRP)?

We are familiar with ‘real negative interest rates’ – the tiny interest rate on your savings account being less than inflation. However, since mid-2014, the ECB has been actually charging the larger eligible banks on their excess deposits. In normal times, banks have generally lent the maximum they can and a minimum of cash in fractional reserve. In bad times however, banks have preferred to keep money on deposit at the central bank even with a negative interest rate on those deposits.

What is the goal of NIRP?

The goal of NIRP is to incentivize banks into removing money from the ECB and lending that money to the general public. They should theoretically do so because they would then receive interest rather than pay it – increasing the amount of money in the system – causing inflation. Each transaction would be recorded at a higher price, and therefore higher GDP – goal achieved.

Why has NIRP largely not worked?

Firstly, most Europeans are, like the rest of the Western world already maxed out with debt and simply do not wish to borrow more. Secondly, European banks who only have to comply to a fractional reserve requirement ratio of 1% are understandably nervous about lending to people who may well default. A -0.2% loss to the ECB is preferable to a 100% default on a loan.

Why not push NIRP even lower – won’t that make banks lend!?

The rate on the deposit facility has already been moved -0.1 to -0.2% but there is a risk of this backfiring. Given that banks are reluctant to lend, they have often responded in creating new charges and fees. However, Deutsche Skatbank in Germany now charges its customers 0.25% on deposits and more banks look set to follow suit. Eventually, customers might quite rightly conclude that rather than paying to keep their money in an insolvent bank they would prefer to simply withdraw it and keep it at home. This may well escalate into a full blown banking crisis if only a fraction of depositors come to the same decision. But why keep cash at home when gold and silver provider a much better protection over the long term – (they are after all still up some 60-70% since the last financial crisis)?

So what happens next?

Since penning this article, the ECB announced last week that it would print EUR 60 billion a per month and in a pre-emptive strike the Swiss National Bank stunned the markets by abandoning the CHF/EUR 1.20 PEG. However, perhaps more significantly, the fact that Draghi has confirmed it is possible to have negative interest rates without immediately causing a bank run will have been noted by other central bankers around the world. This gives them a much needed option in doing ‘whatever it takes’ to keep us on course in their monetary experimentation voyage into the great unknown.