In July of this year, the European Central Bank (ECB) ended its historic eight-year policy of negative interest rates. Motivated by the European debt crisis, the ECB slashed interest rates below zero in an effort to push banks to lend more and boost economic growth in June 2014. An unorthodox approach to monetary policy—the announcement made headlines for its experimental attempt to prop up a eurozone economy that was showing strong signs of deflation.
What do negative interest rates mean?
One of the primary responsibilities of central banks is to make it more or less attractive for households and businesses to save or borrow. They achieve this through the use of monetary policy tools such as interest rates. The implementation of negative interest rates by the ECB appeared to be a rewriting of the conventions of economics at the time of its introduction. Banks have traditionally operated in such a way that savers earn interest on deposits and borrowers pay interest on loans. Interest rates of below zero flip this concept on its head, with lenders paying to hold their money on deposit in the bank while borrowers are paid to take on loans.
Sub-zero: A failed experiment?
As the era of the negative interest rates experiment has now drawn to a close in the eurozone, the results of the policy have been mixed with slow growth. The ECB has estimated that extra bank lending increased by an average of 0.7 per cent and that the policy created an extra 0.4 to 0.5 percentage points of economic growth. But the policy was not entirely well received by member states. Critics of the policy felt that it created asset bubbles and encouraged cash hoarding. Other opponents felt it unfairly hurt the yield on European pension savings. The Bank of Japan (BoJ) is now the only remaining central bank adopting negative rates. Despite pressure to protect the strength of the Yen, the BoJ continues to stick to dovish monetary policy as underlying demand remains weak and inflation remains low at 3 per cent.
Inflation running rampant
The decision by monetary policymakers to increase interest rates has come amidst a rapid surge in eurozone inflation. Record high price levels have induced ECB president, Christine Lagarde, to make a U-turn on the policy of negative interest rates, with the ECB raising rates for the first time in 11 years last July.
Up until then, the ECB was charging banks minus 0.5 per cent on surplus deposits before moving the key rate to zero. Rates were hiked further in September by a record margin of 75 basis points on the back of inflation of 9.1 per cent in August. The ECB is expected to continue to increase rates in the coming months to bring inflation back down towards the bank’s target of 2 per cent. Philip Lane, the ECB’s Chief Economist, has signalled that planned future increases will likely come in smaller increments.
Europe’s 25-year inflation high is largely driven by soaring energy prices, which are rising at an annual rate of 38.3 per cent, due to Russia’s invasion of Ukraine. Around the world, monetary policymakers are turning to hawkish rate hikes to wrest control of surging prices. US Federal Reserve Chair Jerome Powell lifted interest rates by a third consecutive three-quarter basis point yesterday with further tightening planned. The Fed forecasts the benchmark rate to rise to 4.4 per cent by the end of the year.
When it comes to interest rate hikes, monetary policymakers have to tread carefully. A fine balancing act is required as aggressive efforts to curb spending may run the risk of triggering a large and deep recession.