The ECB Announced Negative Rates - Here's How It Works

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ECB President Mario Draghi last night announced that the bank’s governing council had decided to lower interest rates on both the refinancing and deposit rates it offers.

We decided to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.15% and the rate on the marginal lending facility by 35 basis points to 0.40%. The rate on the deposit facility was lowered by 10 basis points to -0.10%. These changes will come into effect on 11 June 2014. The negative rate will also apply to reserve holdings in excess of the minimum reserve requirements and certain other deposits held with the Eurosystem.

The ECB also prepared for its own version of quantitative easing but it’s negative interest rates that have really got the attention of markets this morning.

So what are the negative rates and why are they important?

Key here is that faced with looming deflation – or at least very low inflation of around 0.5% across the EU area and outright deflation in some nations – the ECB is trying to get money circulating back out and through the economy.

So by charging the banks to hold reserves “in excess of the minimum reserve requirements” the bank is trying to say we’ll charge you for the money to be held with us so get out there and lend it to business and get this economy moving.

At the same time, the banks will not want to offer anything by way of decent interest rates to depositors, which is also a signal to depositors to follow the lead and look elsewhere to invest their money.

So, even though the ECB policy will drive up stock markets – the DAX in Frankfurt was above 10,000 at one point last night for the first time ever – the ECB’s hope is that they will be able to replicate the situation which has occurred here in Australia.

Indeed, the hope for the ECB would be that like the RBA governor after this month and many previous months’ meetings, Draghi will be able to say:

Interest rates are very low and for some borrowers have edged lower over recent months. Savers continue to look for higher returns in response to low rates on safe instruments.

It’s going to be hard to fight off deflation in Europe and the ECB is far from done yet.

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